Volatility, rather than abundance per se, drives the "resource curse" paradox

Commodity Price Volatility and the Sources of Growth. By Tiago V. de V. Cavalcanti, Kamiar Mohaddes, and Mehdi Raissi
IMF Working Paper No. 12/12
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012012

Summary

This paper studies the impact of the level and volatility of the commodity terms of trade on economic growth, as well as on the three main growth channels: total factor productivity, physical capital accumulation, and human capital acquisition. We use the standard system GMM approach as well as a cross-sectionally augmented version of the pooled mean group (CPMG) methodology of Pesaran et al. (1999) for estimation. The latter takes account of cross-country heterogeneity and cross-sectional dependence, while the former controls for biases associated with simultaneity and unobserved country-specific effects. Using both annual data for 1970-2007 and five-year non-overlapping observations, we find that while commodity terms of trade growth enhances real output per capita, volatility exerts a negative impact on economic growth operating mainly through lower accumulation of physical capital. Our results indicate that the negative growth effects of commodity terms of trade volatility offset the positive impact of commodity booms; and export diversification of primary commodity abundant countries contribute to faster growth. Therefore, we argue that volatility, rather than abundance per se, drives the "resource curse" paradox.


Excerpts

I. INTRODUCTION

Finally, while the resource curse hypothesis predicts a negative effect of commodity booms on long-run growth, our empirical findings (in line with the results reported in Cavalcanti et al.  (2011a) and elsewhere in the literature) show quite the contrary: a higher level of commodity terms of trade significantly raises growth. Therefore, we argue that it is volatility, rather than abundance per se, that drives the "resource curse" paradox. Indeed, our results confirm that the negative growth effects of CTOT volatility offset the positive impact of commodity booms on real GDP per capita.

VI. CONCLUDING REMARKS

This paper examined empirically the effects of commodity price booms and terms of trade volatility on GDP per capita growth and its sources using two econometric techniques. First, we employed a system GMM dynamic panel estimator to deal with the problems of simultaneity and omitted variables bias, derived from unobserved country-specific effects.  Second, we created an annual panel dataset to exploit the time-series nature of the data and used a cross-sectionally augmented pooled mean group (PMG) estimator to account for both cross-country heterogeneity and cross-sectional dependence which arise from unobserved common factors. The maintained hypothesis was that commodity terms of trade volatility affects output growth negatively, operating mainly through the capital accumulation channel.  This hypothesis is shown to be largely validated by our time series panel data method, as well as by the system GMM technique used, suggesting the importance of volatility in explaining the under-performance of primary commodity abundant countries.

While the resource curse hypothesis postulates a negative effect of resource abundance (proxied by commodity booms) on output growth, the empirical results presented in this paper show the contrary: commodity terms of trade growth seems to have affected primary-product exporters positively. Since the negative impact of CTOT volatility on GDP per capita is larger than the growth-enhancing effects of commodity booms, we argue that volatility, rather than abundance per se, drives the resource curse paradox.

An important contribution of our paper was to stress the importance of the overall negative impact of CTOT volatility on economic growth, and to investigate the channels through which this effect operates. We illustrated that commodity price uncertainty mainly lowers the accumulation of physical capital. The GMM results also implied that CTOT volatility adversely affects human capital formation. However, this latter effect was not robust when we used an alternate GARCH methodology to calculate CTOT volatility. Therefore, an important research and policy agenda is to determine how countries can offset the negative effects of commodity price uncertainty on physical and human capital investment.

Another notable aspect of our results was to show the asymmetric effects of commodity terms of trade volatility on GDP per capita growth in the two country groups considered. While CTOT instability created a significant negative effect on output growth in the sample of 62 primary product exporters, in the case of the remaining 56 countries (or even in the full sample of 118 countries) the same pattern was not observed. One explanation for this observation is that the latter group of countries, with more diversified export structure, were better able to insure against price volatility than a sample of primary product exporters.  Finally, we offered some empirical evidence on growth-enhancing effects of export diversification, especially for countries whose GDP is highly dependent on revenues from just a handful of primary products.

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 (SWF) as well as stabilization funds, a suitable exchange rate regime, and export diversification can all have beneficial growth effects. Moreover, recent academic research has placed emphasis on institutional reform. By establishing 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. We await better data on institutional quality to test this hypothesis. Clearly, fully articulated structural models are needed to properly investigate the channels through which the negative growth effects of volatility could be attenuated. This remains an important challenge for future research.

CPSS-IOSCO's Requirements for OTC derivatives data reporting and aggregation: final report

Requirements for OTC derivatives data reporting and aggregation: CPSS-IOSCO publishes final report
January 17, 2012
http://www.bis.org/press/p120117.htm

The Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) have published their final report on the OTC derivatives data that should be collected, stored and disseminated by trade repositories (TRs).

The committees support the view that TRs, by collecting such data centrally, would provide authorities and the public with better and more timely information on OTC derivatives. This would make markets more transparent, help to prevent market abuse, and promote financial stability.

The final report reflects public comments received in response to a consultative version of the report published in August 2011. Following the consultation exercise, the report was expanded to elaborate on the description of possible options to address data gaps.

The report was also updated to reflect recent international developments in data reporting and aggregation requirements stemming from the Legal Entity Identifier (LEI) workshop in September 2011 and other efforts under the auspices of the Financial Stability Board (FSB), in support of a request by the G20 at the Cannes Summit, to advance the development of a global LEI.

As the report indicates, some questions remain regarding how best to address current data gaps and define authorities' access to TRs. As requested by the G20, two internationally coordinated working groups will address these questions in the coming year. The FSB will establish an ad hoc group of experts to further consider means of filling current data gaps, while the CPSS and IOSCO will establish a joint group to examine authorities' access to trade repositories.


Report Background

The report addresses Recommendation 19 in the October 2010 report of the FSB, Implementing OTC derivatives market reforms, which called on the CPSS and IOSCO to consult with the authorities and the OTC Derivatives Regulators Forum in developing:

(i)    minimum data reporting requirements and standardised formats, and

(ii)   the methodology and mechanism for data aggregation on a global basis. A final report is due by the end of 2011.

The requirements and data formats will apply both to market participants reporting to TRs and to TRs reporting to the public and to regulators. The report also finds that certain information currently not supported by TRs would be helpful in assessing systemic risk and financial stability, and discusses options for bridging these gaps.

Issues relating to data access for the authorities and reporting entities are discussed, including methods and tools that could provide the authorities with better access to data. Public dissemination of data, it is noted, promotes the understanding of OTC derivatives markets by all stakeholders, underpins investor protection, and facilitates the exercise of market discipline.

The report also covers the mechanisms and tools that the authorities will need for the purpose of aggregating OTC derivatives data.


Notes to editors

• This report was originally published in August 2011 as a consultative report.
• The CPSS serves as a forum for central banks in their efforts to monitor and analyse developments in payment and settlement arrangements as well as in cross-border and multicurrency settlement schemes. The CPSS secretariat is hosted by the Bank of International Settlements (BIS).
• IOSCO is an international policy forum for securities regulators. The Technical Committee, a specialised working committee established by IOSCO's Executive Committee, comprises 18 agencies that regulate some of the world's larger, more developed and internationalised markets. Its objective is to review major regulatory issues related to international securities and futures transactions and to coordinate practical responses to these concerns.
• Both committees are recognised as international standard-setting bodies by the Financial Stability Board (www.financialstabilityboard.org)

The sustainability of pension schemes

The sustainability of pension schemes, by Srichander Ramaswamy
BIS Working Papers No 368
http://www.bis.org/publ/work368.htm


Abstract

Poor financial market returns and low long-term real interest rates in recent years have created challenges for the sponsors of defined benefit pension schemes. At the same time, lower payroll tax revenues in a period of high unemployment, and rising fiscal deficits in many advanced economies as economic activity has fallen, are also testing the sustainability of pay-as-you-go public pension schemes. Amendments to pension accounting rules that require corporations to regularly report the valuation differences between their defined benefit pension assets and plan liabilities on their balance sheet have made investors more aware of the pension risk exposure for the sponsors of such schemes. This paper sheds light on what effects these developments are having on the design of occupational pension schemes, and also provides some estimates for the post-employment benefits that could be delivered by these schemes under different sets of assumptions. The paper concludes by providing some policy perspectives.


8  Summary and policy issues (edited)

A weak macroeconomic environment and unusually low real interest rates in many countries have put the funding challenges faced by occupational and public pension schemes in the spotlight. This paper took a simple actuarial model to quantify how the cost of funding DB pension schemes increase as the real rate of return in asset markets falls. If real returns on pension assets are assumed to be lower by 0.5% compared to their historical averages, service costs of DB schemes would be 15% higher than in the past for the same benefit payments. Converting final salary pension schemes to career average schemes (and not altering the percentages applied) would lower pensions by 20–25% assuming that real wages grow at the rate of 1–1.5% per annum.

Declining mortality rates will put further upward pressure on the contribution rates needed to fund these schemes. When the expected increases in longevity are priced into the actuarial model for computing the service cost, this cost is likely to be 10% higher than estimates presented in the paper. Increasing longevity as well as demographic changes that point to a rise in the old-age dependency ratio poses challenges to the sustainability of PAYG schemes. The projected increase in old-age dependency ratio suggests that in many countries the contributions to PAYG schemes have to increase by 20% from current levels in 2020 to pay pensions. But as PAYG schemes that service current pensions from employee contributions and taxes do not report the contractual pension liabilities, estimating the funding shortfalls these schemes might face going forward is a challenge.

In contrast to PAYG schemes and some funded public pension schemes, occupational DB schemes have to comply with accounting standards to report the market value of their pension liabilities and the assets that back them so that potential funding shortfalls faced by these schemes can be quantified. Unusually low real interest rates and poor financial market returns in the past decade have had an adverse impact on the coverage ratio of these schemes through the valuation effects on liabilities and lower returns on pension assets. Estimates of the coverage ratio of occupational DB schemes based on these returns would point to a funding deficit of 10 to 20 per cent against their pension liabilities. The size of any deficit that eventually materialises over the long lives of these schemes, however, would depend on future returns – which are unknown.

For occupational DB schemes that face large funding shortfalls, employer contributions will have to rise to improve the coverage ratio of these schemes. At the same time, increasing longevity and falling real yields against the backdrop of a weak macroeconomic environment are raising the service costs of DB schemes and adding to the upward pressures on required contribution rates. Recent amendments to pension accounting standards, which require companies to provide more disclosures in their financial statements on the risks the DB scheme poses to the entity and to report the net gains or losses from their DB pension plans on their balance sheet, are likely to accelerate the shift out of occupational DB plans into DC plans. This is because DC plans limit the contractual liabilities of employers to the contribution rates to be paid for the current service period of the employee.

A progressive shift from DB to DC schemes can have material implications for post-employment benefits because it exposes employees to the investment risks on the pension assets. In addition to this risk, beneficiaries of DC plans will also be exposed to the principal risk factors that determine annuity payments, namely level of real interest rates and the projections of mortality rates into the future when the actual annuity payments will be made. Using a simple model to estimate the retirement income from DC schemes, the numerical results presented in Table 2 showed that when contributions to DC schemes are 18% of salaries over a 30-year period and the returns net of administrative expenses on plan assets are 2% higher than the rate at which wages grow, post-employment benefits from a DC scheme would roughly be 43% of the final salary. The excess return assumption of 2% is based on the following input variables in the model to compute retirement income for DC plans: real yield on long-term bonds is 2%; equity risk premium over the returns on long-term government bonds is 3%; plan assets have an equal share of bonds and equities; administrative expenses are 0.5% of plan assets; and the annual real wage growth rate is 1.25%.

The quantitative analysis presented in this paper provides some insights on the possible trade-offs that may be available for public policy on the design of sustainable pension schemes. For example, the internal rate of return on the notional assets of PAYG schemes will be approximately equal to the rate of real GDP growth of the local economy, which is expected to be 2% or lower in advanced economies. The actuarial model showed that service cost of a pension scheme will be high when the rate of return on the pension assets is low. A funded public pension scheme, on the other hand, will be able to raise the level of return on pension fund assets by investing them in higher growth markets. Estimates using the actuarial model suggest that a 50 basis points increase in real returns lowers the service cost of the pension scheme by 15%. Funded pension schemes therefore offer the prospect of lowering service costs and to be able to better align the pension benefits offered by these schemes to the contribution rates received.

Public policy may also be needed to develop efficient markets for pricing annuity risk as occupational DC plans become the preferred post-employment benefit scheme offered by employers. Efficient markets for pricing annuities will in turn depend on how the market for managing and hedging longevity risk develops. As more employers progressively shift towards DC schemes for providing post-employment benefits, regulatory policies might be needed to restrict the range of permissible investment options available for plan assets to avoid unintended risks being taken by the plan beneficiaries, and to set mandatory minimum contribution rates for participating in DC schemes. Finally, considering that plan beneficiaries in DC schemes are exposed to interest rate risk at the time of converting plan assets into an annuity, the pros and cons of providing insurance policies that guarantee a minimum real yield at which these assets can be converted into an annuity will have to be examined.