Emerging markets and commodity prices

There is an increasing debate about the ability of emerging markets to continue growing at the pace at which they have been growing over the last years. The last decade has been remarkable for emerging markets as a group. The chart below compares the growth rate of (real) GDP for the group of advanced economies and for the group of emerging and developing economies (definitions and data coming from the IMF).

After decades where emerging markets were growing at best at the rate of the advanced economies, since 2000 we see a clear gap in growth rates and a strong process of convergence or catching up. The difference is large, as large as 4 or 5 percentage points in many years. 

There are many potential reasons why the fate of emerging markets changed since 2000. From a regional perspective Asia was already doing well in previous decades and continued to grow at a strong or even stronger rate. Some countries in Latin America started growing at decent rates after really weak performance in the previous decades. And African growth rates have been at the highest level in many years.

During those years we have also seen another strong trend in the world economy, the fast growth in the prices of commodities. The fact that these prices have increased can be seen as the outcome of strong growth in the world (fueled by emerging markets). But the causality also runs backwards for some of these countries: it was the strong demand coming from certain economies that pushed prices up and allowed those countries that produce commodities to see growth finally happening. 

The data shows that indeed, the phenomenal growth in emerging markets post-2000 coincided with positive developments in commodity prices. The figure below compares the growth in GDP of emerging and developing countries (from the previous figure) with the growth in the price of commodities during the same years [Note: the series used for commodity prices is Commodity Industrial Inputs Price Index includes Agricultural Raw Materials and Metals Price Indices from the IMF; including food prices or oil prices to the index does not change the correlation at all].

What is remarkable about the data is not that there is a strong correlation in the post-2000 period but also that this correlation has become much stronger than before. For the reasons outlined above it makes sense that these two series are correlated, what is interesting is that the correlation has become strong in the years where growth in emerging markets has taken off. And this cannot simply be the fact that emerging markets matter more in the world economy (and therefore have a strong influence on the price of commodities). If this was the case we would simply expect the other countries (advanced) to have a much stronger influence in the earlier years, but this is not the case. 

To explain the correlation above we probably need a combination of qualitatively different growth during these years that is putting demand pressure on prices while at the same time the producers of commodities (mostly emerging markets) benefit from this demand and grow at higher rates. But regardless of the explanation, it is important to realize how the fate of emerging markets and commodities prices is much more linked than in the past.

Antonio Fatás

China getting close to hit the Great Wall

In a New York Times column Paul Krugman makes the point that the Chinese economy is going to have difficulties continuing growing with its current model. He uses the expression that China is about to hit its Great Wall (from an economic point of view). A few years ago, Ilian Mihov and I wrote a paper that we labelled "The Great Wall" to talk about the challenge that many countries face going beyond a certain level of development. Others have referred to this as the "middle-income trap". Let me repost a blog post from last year (March 2012) where we updated our analysis, for those interested in the topic.

Reposted from March 26, 2012


Last week China's Vice Premier Li Kequiang mentioned that reforms in China have now entered "a crucial stage and cannot be delayed." And a few days earlier Prime Minister Wen Jiabao explicitly referred to the need of a second phase of growth and talked about how "political structural reform" needed to follow economic reform. In its absence "such a historic tragedy as the Cultural Revolution may happen again." These two quotes fit nicely with an article we published three years ago about how China needed to increase the pace of reforms to eventually join the club of rich economies.

The argument that institutional quality is important for growth is not new and many have written about it, but our emphasis is on the changing relationship between institutions and growth at different stages of development. In the early phases of growth the relationship between institutions and income per capita is very weak (no need for radical reform) while it becomes very strong for higher levels of development.

We just updated our original chart with more recent data (2010) and the result is shown below (institutional quality is measured as the average of the six governance indicators produced by the World Bank; GDP per capita is adjusted for PPP).

The conclusions of our previous work remain. The chart suggests that there are two phases of growth. A first one where institutional reform is less relevant. When we look at the chart we see almost no correlation between quality of institutions and income per capita for low levels of development. To be clear, not everyone is growing in that section of the chart so it must be that there is something happening in those countries that are growing (moving to the right). Success in this region is the result of good "policies" in contrast with the deep changes in institutions that are required later (you can also call them economic reforms as opposed to institutional reforms).

The second phase of growth takes countries beyond the level of $10,000-$12,000 of income per capita. It is in this second phase when the correlation between institutions and income per capita becomes strong and positive. No rich country has weak institutions so reform becomes a requirement to continue growing.

In our original article we called this region "The Great Wall". Economies either climb the wall to become rich or they hit it and get stuck. Economies that illustrate the notion of hitting the Wall are the former Soviet Union that collapsed after not being able to "go through" the Wall with its institutional setting; or Latin American economies such as Venezuela or Argentina which have incomes around that level and do not seem to be able to take their economies to the next step.

We named that threshold "The Great Wall" as a reference to China: a country that over the last decades has displayed the highest growth of income per capita in the world with a set of institutions that are seen as weak (at least relative to advanced economies). China is once again highlighted in our updated chart above and what we can see is that, while it is still in the first phase of growth, it is getting closer and closer to the Wall. It is therefore not a surprise that in the last weeks we have heard senior officials in China talking about the challenge of the next phase of growth.

Characterizing the two phases of growth and making explicit the necessary reforms that are needed to go from one to the other is not an easy task and it is likely to lead to different policy recommendations for different countries. For a very detailed analysis of institutional reform, I strongly recommend the recent book by Daron Acemoglu and James Robinson Why Nations Fail. Their work highlights the need to develop inclusive institutions to allow for the second phase of growth (you can read their thoughts at their blog and find there a link to their book). Others have presented alternative views of how to think about the different phases of growth, as it is the case of Dani Rodrik, who emphasizes the role that different sectors play in this transition.

Antonio Fatás

Show me the model

Most of the commentary one reads these days about the negative consequences of the policies set by central banks (low-interest rate and quantitative easing) are not backed by any economic model that I know. The criticisms make constant reference to "distorted" interest rates, "artificially low" cost of capital, mispricing of bonds and other assets as channels through which the misguided policies of central banks are causing low growth, uncertainty and volatility. But what is the economic model that can provide a theoretical justification to an environment where the central bank can significantly affect equilibrium asset prices and interest rates for a prolonged period of time and without causing inflation? I have not seen it yet.

When we teach the effects of monetary policy we tend to use economic models that have a Keynesian flavor to it, with some form of price rigidity and where changes in the nominal interest rate by central banks have a short-run impact on real interest rates (as inflation moves slowly). But this only works in the short run, while prices are rigid. Once price flexibility kicks in there is no way for the central bank to have an influence on relative prices (of assets or goods and services). 

But what I find most puzzling is that those who talk about distorted and manipulated interest rates are the ones who tend to criticize the predictions of Keynesian models in the first place! They are the ones who tend to use as a justification for their arguments models where central banks have no impact on the economy even in the short run. How is it that now suddenly central banks have become so powerful that they can determine "real" (relative) prices for an extended period of time? I need to see the model.

Antonio Fatás

The New Normal is to forget economic history

Mohamed El-Erian in the Financial Times today puts forward again the argument that quantitative easing has generated little benefits and is now creating unnecessary volatility in financial markets. He presents the current monetary policy stance and the potential exit strategy as a unique experience that is generating distortions and volatility in financial markets that we have never seen before.

He uses two very simple examples of how bond returns are becoming volatile as interest rates start moving up. The logic is simple and well understood by anyone who understands bond markets: a fixed-rate bond that was issued yesterday will see its price change if interest rates move (in an unexpected manner) over the horizon over which the bond is outstanding. Here is a quote from his article:


"As a simple illustration, consider the 5-year US Treasury note issued at the end of March. A low coupon and relatively modest yield curve roll-down meant the most investors could reasonably expect at issuance was a total return of 2.7 per cent over the subsequent two-year period. If, however, five-year rates were to go up by 70 basis points, which in fact they did over the next three months, the bond was already 3.25 per cent under water (as of the June 25 close), altering the risk/return outlook."

Correct. Bonds that were issued in March under the assumption that interest rates will remain low over the next five years now look like a poor investment because the market today is looking at a scenario of higher interest rates. Without debating on whether the market is right or wrong, this is something that is standard in bond markets. News on future interest rates will cause volatility on bond prices. By reading the article one gets the impression that the current volatility is unusual and that it is the fault of the zero interest rate policy of central banks and quantitative easing. Quoting from the article:

"This dynamic was exaggerated when securities were artificially compressed by experimental central bank policy."

I can see the market is indeed getting worried about the exit strategy and that we are potentially heading for some volatile period in terms of interest rates. But what is nor correct is to argue that what we are seeing is that unusual. Any time monetary policy gets tighter (regardless of the level of interest rate), we see volatility in interest rates. And in previous episodes we have seen volatility that is possibly as high or higher than what we have witnessed so far. 

Below are the plots of the interest rate on the 5-year US Treasury note around the current episode and during the 1994 episode of monetary tightening by the Fed.

The two episodes are not directly comparable but as we can see that during the 1994 episode, 5-year rates increased from 5% to 7% in a matter of 2 to 3 months (in the current episode we have seen rates increasing by about 0.8% in the last two months). This time it is very likely that 5-year rates will continue to go up and possibly increase by more than in previous periods of monetary tightening (if we measure it in percentage points). And this might be a surprise to some who thought that growth will never return and it might not be a surprise to those who are indeed betting that interest rates will go up and are trying to make money on that bet (as Pimco has done in the past). Putting the blame on this volatility on the central bank and the current monetary policy stance is not correct. Markets trade on differences of opinion about the future. Some will be right and some will be wrong and these will generate volatility in ex-post returns. While central banks can be proactive and provide forward guidance on their policies, they cannot control everyone's expectations about future interest rates. If we want to judge central bank policies and their communications we need to wait and see if the forward guidance they provided was a good indication of what they did later.

Antonio Fatás

Central Banks: powerful or powerless? Make up your mind.

In my previous blog post I criticized the latest annual BIS report on several grounds. One of them was their analysis of monetary policy. Let me extend some of the arguments I made yesterday because I see the same inconsistencies (and errors) being brought up by others.

I find it surprising that those who argued that QE had very little effect in the economy are now ready to blame the central bank for all the damage they will do to the economy when they undo those measures. So they seem to have a model of the effectiveness of central banks that is very asymmetric - I would like to see that model. It is also surprising that those who express concern about the excessive expansionary nature of monetary policy do not bother comparing the performance of inflation against its target. Shouldn't we measure output and performance when judging central banks?

Let me bring back a chart from the BIS report that I included yesterday in my post, the one where they compare interest rates in advanced and emerging economies against what the Taylor rule would suggest (click on the image for a larger version).

The blue line represents interest rates as suggested by the Taylor rule. The grey area represents some uncertainty around how this rule should be formulated. The red line is the actual interest rate set by central banks. Since 2002 the red line is below the blue line almost every year (with the exception of the Fall of 2008 in advanced economies). In some cases the distance is large (as many as four percentage points). The BIS report concludes that central banks are playing with fire, that they are setting interest rates too low and that this can be a source of inflation and/or asset bubbles.

But how can it be that central banks get the interest rate wrong for more than a decade always in the same direction and inflation remains within its target? What economic model can generate that behavior of inflation? How can it be that central banks are so powerless at controlling inflation? And if they are, why do we worry about these interest rates? Some will respond to these questions by arguing that we have seen inflation in some of these countries but it is a different type of inflation: asset price inflation. I have two responses for that:

1. I do not know of any macroeconomic model where expansionary monetary policy does not generate inflation defined as the increase in the prices of goods and services. While I am willing to accept that central banks might influence asset prices via their communications, I still have a problem with the way the Taylor rule is calculated above. The Taylor rule was originally designed and has been used later as a way to think about a benchmark to stabilize inflation (in goods and services(. If it is not playing any role anymore then we need to produce a new framework (theory) that explains why monetary policy does not affect inflation anymore, we need a new Taylor rule.

2. While it is true that we have witnessed some crazy behavior in financial markets over the last two cycles, the correlation with the way monetary policy has been conducted is weak. I participated in a study at the IMF in 2009 (part of their World Economic Outlook, see the chapter here) where we studied whether there was evidence that countries where monetary policy was more expansionary according to a Taylor rule (and other rules) saw bigger asset price bubbles. The evidence showed that the correlation was weak or inexistent. So there is limited evidence that monetary policy is the cause of the volatility we have seen in asset prices in the last two cycles. [Interestingly, I must admit that when I started the project I had very strong priors that we would find some strong evidence that monetary policy was behind bubbles in advanced economies. But the evidence was not there, so I changed my mind.]

Antonio Fatás

BIS: Bank for Inconsistent Studies

The BIS just published its annual report (and some of its arguments are also presented in a lecture that Raghuram Rajan gave at the BIS at the time of the launch). Paul Krugman has posted a reaction to the report where he expresses surprise at how the report seems to ignore evidence we have accumulated during the crisis. I will not repeat Krugman's arguments here but instead focus on what I perceive to be a series of inconsistencies in the arguments used in the BIS report - inconsistencies that are also present in the lecture by Rajan.

Both the BIS report and the speech by Rajan present a critical view of the fiscal and monetary policy stimulus we have witnessed over the last years. It is a soft criticism as they seem to agree that some of it was needed, but then they present arguments that suggest that both policies have gone too far, are not being effective, they might be slowing down growth and they will be a source of uncertainty going forward. The criticism is not always accompanied with an alternative. There is a recognition that this is a crisis caused by low demand but at some point the arguments is turned around to argue that more demand might not be a solution (given all the structural problems we have).

The report is long so let me focus on two issues where I feel their arguments are not only not supported by the evidence but also lack some internal consistency.

The report in unclear about whether the short-run and long-run recipes to get out of the crisis should be different. Everyone understands that some of the trends that we witnessed before the crisis were unsustainable from a long-run point of view. Some of the spending patterns of the private sector (and the public sector in some cases) were leading to an accumulation of debt that needed a correction. No disagreement here. But when the adjustment took place it did it in a way which was not efficient. A deep recession started (and the BIS report explains very clearly why lack of demand created this recession).

How do you deal with a recession that is defined as a period where output is below its trend? Even if we agree that the trend is not growing as fast as before (although I am not sure we have enough evidence to prove this but I am open to the argument), isn't it obvious that we are producing below trend? And if we are, what we need are policies that restore full employment, that bring output close to equilibrium. These are the policies that can increase output in the short run. Supply (structural) policies can be a source of output in the long run and there might be great benefits to those policies as well, but unless one is willing to argue that output today is at potential, there must be room for demand policies. The BIS does not take a clear stance on this. It simply criticizes those who argue in favor of additional stimulus on the basis that they ignore structural problems. But this is not correct. Those of us who have argued in favor of demand policies have never denied that there is room for structural reform in many advanced economies. It is a matter of timing.

And what about the evidence? The argument from Rajan that "what is true is that we have had plenty of stimulus." is at odds with the evidence. Both fiscal policy and monetary policy have been less expansionary (or more contractionary) than in any previous recession.

When it comes to monetary policy the report adopts a similar attitude: while it admits that many of the policies were necessary there is a criticism that central banks have gone too far and now they are going to cause trouble as they clean up the mess that they made. Let me focus on one of the arguments they make: that central banks has been too accommodative and that interest rates have been too low. The report makes the argument that this has been going one for years now.

Below is a chart from section VI.6 of the BIS report to show that interest rates are too low today and they have been low for most of the years since 2000, both in advanced economies and emerging markets.

The chart uses the Taylor rule as a benchmark for what constitutes appropriate interest rates. The Taylor rule was proposed by John Taylor in 1993 to describe the behavior of the US Federal Reserve during the 80s. The tool became very popular because it could explain interest rates just by using two variables: inflation and the output gap. Anyone who has studies Taylor rules knows that the moment you apply it to a different period or a different country, the rule does not work as well. There are many problems: which is the appropriate measure of the output gap or inflation, are the coefficients changing over time, during recessions, etc.

But the fundamental issue with the Taylor rule is about the appropriate benchmark for the real interest rates in normal times. The original Taylor rule used the value 2% as the "natural" real interest rate.  This number worked well because it was coming from the data that Taylor was looking at (in some sense Taylor estimated this number using data from the 80s in the US). But this is an equilibrium concept and as such it can change. What we teach our students is that this rate is determined by the balance between Saving and Investment. What we know is that since the end of the 90s some countries started saving at much higher rates than before, what Ben Bernanke called the Saving Glut back in 2005. What we also know is that the global recession has pushed Saving higher in depressed economies and that we have seen limited reason to invest (e.g. the anecdotal reference to companies sitting in a pile of cash not wanting to invest). In that environment, we expect the equilibrium real interest rate to go down significantly. The BIS report and Rajan's speech keep referring to the "Keynesian" view that equilibrium real interest rates have turned negative. What is "Keynesian" about that view? The Saving / Investment imbalance is an equilibrium concept that is present in any economic model I know. The BIS report takes no stance in this debate, it simply criticizes others. What is the real equilibrium interest rate in the world economy today according to the BIS? 2%?

Finally, if it is true that monetary policy has been so accommodative for about 13 years, where is inflation? The Taylor rule was partly proposed as a benchmark on how to maintain a stable rate of inflation. If we keep the interest rate below what is appropriate for 13 years we should see massive inflation everywhere in the world. But there is no inflation. Isn't this enough evidence to stop the BIS from producing the chart above as a proof that central banks have gone too far?

Yet another day when one feels that this crisis has been a wasted crisis for economists to learn about our mistakes.

Antonio Fatás

The power of statistics (Ferguson and the WSJ)

Dean Baker complains about the high number of inconsistencies and mistakes that Niall Ferguson manages to put together in a Wall Street Journal piece written three days ago. There seems to be a pattern here given the article that Niall Ferguson had written just a few days earlier (June 7) also in the Wall Street Journal.

The way I found that second article is interesting and it shows the negative influence of these articles -- even if the mistakes are obvious. I found that second article by Ferguson because as I was teaching some of my students here at INSEAD about the connections between institutions and growth, one of them mentioned an article in the Wall Street Journal that was showing data that contradicted some of my statements. The article, by Niall Ferguson claimed that according to the using data from the Doing Business report from the World Bank, ranked the US as the sixth-worst country in the world when it comes to how easy it is to do business -- I was, of course, showing data that the US remains one of the countries on top of that list.

[Update: Here is the quote from Ferguson's article:"In only around 20 countries has the total duration of dealing with "red tape" gone up. The sixth-worst case is none other than the U.S., where the total number of days has increased by 18% to 433."]

I had to read the article several times to understand how the statistics from the World Bank report were manipulated (I cannot find another word) to produce such a misleading picture of (excessive) regulation in the US. Here is the trick: what Niall Ferguson does is to look for countries that have gotten worse when it comes to the number of days it takes to get certain procedures done. It then ranks them by this criteria (the increase in the number of days) measured in percentage terms. Because the US has indeed increased the number of days and because the initial number was very low, measured as a % makes the US look like the 6th worst country in the world (when you go from 1 day to 2 days it is a 100% worsening; much better than when you go from 300 days to 500). Of course, if you look at the actual number of days the US remains one of the best places to do business in the world (according to this report). The US is ranked #4 in the overall ranking - same position as last year- and #13 when it comes to "Starting a Business" indicators (one position lower than last year).

I am sure that there are some areas in which the US is not as good as it was as a place to do business. But misusing statistics to make the US look like the 6th worst country in the world is just wrong. And the fact that the argument was convincing enough for that student in my class to bring it up as an argument shows the power that media can have in the political debate.

Antonio Fatás