Ezriel M. Brook and Enzo R. Grilli
The problem of instability in the prices and export earnings of primary commodities is well known. Developing countries have, for more than two decades, emphasized the adverse impact of these price and export revenue fluctuations on their economies. The problem has been the subject of much theoretical and empirical investigation and controversy. Even greater has been the controversy over the appropriate international policy actions to deal with this problem. Despite considerable political pressure by the developing countries and a variety of technical proposals elaborated mostly by agencies of the United Nations (including the Fund and the Bank), practical progress in this field has been slow during the past 25 years.
The debate itself has been marred by considerable confusion. Failure to differentiate between the problem of short-term instability of prices and earnings and the problem of long-term growth of export revenue from primary commodities has often led to confusion over what the objectives of any national and international actions should be. Even when the short-term and long-term problems were clearly differentiated and attention was focused on short-term instability in prices and export earnings, price stabilization was often assumed to yield revenue stabilization as well. Furthermore, although the critical question of the distribution of gains from price stabilization has been intensely debated at the theoretical level, it has received little, if any, empirical attention. Primary commodities have often been chosen for international schemes for market price stabilization, on the basis of technical criteria (such as storability) and the importance of specific commodities to developing countries as revenue earners. These criteria are clearly unsatisfactory, since they rest on the implicit assumption that producers (most often developing countries) would automatically benefit from price stability.
Recently, mostly as a result of the integrated program for commodities put forward by the United Nations Conference on Trade and Development (UNCTAD), there has been a revival of interest in international commodity trading arrangements—buffer stocks in particular—designed to reduce short-term fluctuations in the prices of primary commodities exported by the developing countries. This has highlighted the short-term problem, but the concentration on international buffer stocks as the main market regulatory instrument has, again, somewhat disguised the relationship between price and revenue stabilization. Moreover, the international discussion over the UNCTAD program has shown that the difference between buffer stock commodity agreements and the export earnings stabilization schemes of the Fund or those of the Lome Convention type has not been fully appreciated. The choice of the commodities to be included in the UNCTAD stabilization program, in addition, was made with no apparent regard for the welfare and income distribution effects of international price stabilization.
Effects of fluctuations
Smoothing out fluctuations in total foreign exchange earnings due to instability in commodity export revenue requires conservative foreign exchange reserve policies. This is even more the case for developing countries, since their international borrowing capacity is limited and they can hardly afford to hold in reserve large amounts of foreign exchange for largely unpredictable shortfalls in export earnings.
The effects of export instability on economic growth have been studied extensively. Though there is still some dispute on this question, the basic conclusion seems to be that the growth of export revenue is a more important determinant of the growth of gross national product (GNP) than the degree of instability of export revenue. However, even if instability in export earnings does not seem to be an insurmountable obstacle to GNP growth, it is clear that export fluctuations make managing the economies of the developing countries more difficult.
Commodity export price fluctuations which are not compensated for by changes in the volume of exports in the opposite direction lead to revenue instability and cause difficulties at the macro-economic level in fiscal revenue and government spending. In addition, however, price fluctuations cause serious economic inefficiencies at the microeconomic level. During periods of tight supply and high prices, there are strains on resources at both the producer and consumer ends. Similarly, during periods of low demand and low prices, productive capacity remains unused, with reductions in profits and labor income to the producing country’s economy. Price instability, moreover, complicates investment planning in industry and often causes unjustified investment booms during periods of high prices, and underinvestment during periods of low prices. For some commodities—such as tree crops and minerals—the correlation that seems to exist between movements in prices and investment causes serious economic losses.
It follows, therefore, that if the objective is to alleviate the economic difficulties caused by export revenue fluctuations at the macroeconomic level, the export earnings stabilization schemes of the Fund or those of the Lome Convention type (such as the STABEX fund) are the appropriate instruments. One can argue the need for liberalizing the conditions under which these schemes became operative and the repayment rules that are built into such schemes, but the purpose of the stabilization instrument is quite clear. On the other hand, if the objective is to avoid the inefficiencies of unused resources at the microeconomic level and to provide a more certain planning environment, as well as more appropriate investment incentives, commodity prices have to be stabilized.
The authors have carried out a theoretical analysis which shows that the source of commodity price instability is a critical factor in determining whether producers or consumers gain from price stabilization in terms of welfare (measured by producer and consumer surplus) and income (measured in terms of total export earnings). The source of price instability (demand or supply) is also important in determining whether or not price stabilization is likely to bring about revenue stabilization.
A two-period analysis was used within the framework of a simple market model. This assumed: (1) linear demand and supply curves; (2) a negatively sloped demand and a positively sloped supply curve; (3) parallel shifts of the demand and supply curves over the two periods; (4) price stabilization at the mean of the prices that would have prevailed in the absence of price stabilization; and (5) demand and supply that reacted instantaneously to price changes.
These were the main results:
• if shifts in demand were the cause of price instability, price stabilization would decrease the total earnings of the commodity exporting countries as well as their welfare;
• if supply shifts were the cause of price instability, price stabilization would increase the total revenue of the commodity exporting countries as well as their welfare;
• stable prices are more conducive to global welfare than unstable prices. Price stabilization provides a net gain to producers and consumers together—that is, gainers can compensate losers and total net gains are always positive;
• if demand shifts are the cause of price instability, stabilizing prices will also stabilize export revenue when demand is price elastic over the relevant range. It will, however, destabilize export revenue when demand is price inelastic over the relevant range (both of these results hold regardless of the value of price elasticities of supply); and
• if supply shifts are the cause of price instability, price stabilization will de stabilize revenue when demand is price elastic over the relevant range (this result holds regardless of the value of the price elasticity of supply). Only when both demand and supply are price inelastic over the relevant range, can price stabilization also stabilize export revenue in a supply shift market.
The theoretical analysis points to the need for the developing countries to distinguish clearly whether their commodity price stabilization is intended to: (1) stabilize export revenue, or (2) maximize revenue and welfare of commodity exporting countries, or (3) minimize export expenditure and maximize welfare of commodity importing countries. It is not at all assured that more than one of these targets can be achieved at the same time. The analysis, moreover, shows that if price stabilization is intended to maximize the income and welfare benefits of the developing countries as producers (exporters), they should choose those commodities whose prices fluctuate mostly as a result of supply shifts. If, on the other hand, the objective is to maximize welfare and minimize import expenditure of developing countries as consumers (importers), they should choose those commodities whose prices fluctuate mostly as a result of demand shifts. The determination of the source of price instability becomes, therefore, a critically important factor in the choice of commodities whose prices can be effectively stabilized through international action.
Source of price instability
An empirical attempt was made to ascertain the source of price instability for a sample of 17 primary commodities traded by developing countries (see Table 1). Two criteria guided the choice of the commodities: (1) their suitability for buffer stock operations (that is, how storable the commodities were), and (2) their relative importance to developing countries.
Sufficiently uniform and reliable statistics for all the 17 commodities included in the sample could only be assembled for the period between 1954 and 1973. Because international market price quotations for some commodities do not accurately reflect the unit prices realized by exporters, it was decided to use unit values of world exports wherever available (for example, for most agricultural commodities) as an alternative to market price quotations. In order to do so, without changing the length of the time series used in the statistical analysis, it was necessary to take 1973 as the terminal year for all the time series used. Reliable data on the unit values of world exports is not even available for agricultural products beyond 1973.
For each commodity, quantity (production and export) deviations from the 1954-73 trend were regressed against price (or export unit values) deviations from the trend over the same period. Linear and semilog trends were used. The source of the price fluctuations was inferred from, the sign of the regression coefficients—a positive sign of the price coefficient was assumed to indicate that demand shifts are the main cause of market price fluctuations, while a negative sign of the price coefficient was assumed to indicate that supply shifts are the main source of market price fluctuations. The standard statistical tests were used to determine the probabilistic significance of the signs of the various coefficients. The results are summarized in Table 2.
|Source of export price fluctuations||Developing countries’ exports larger than imports||Developing countries’ imports larger than exports||Potential benefit from stabilizing export prices||Inconclusive result 1|
Less than 10 per cent significance.
Less than 10 per cent significance.
Benefits to LDCs
In the case of those commodities where developing countries as a group are the dominant exporters and where price fluctuations are caused by supply shifts, international market price stabilization benefits the developing countries. Similarly, developing countries benefit from international price stabilization in those commodities where they are the dominant importers and where market price fluctuations are caused by demand shifts. Our empirical investigation of the sources of commodity price instability for the sample panel of 17 primary commodities shows that developing countries as exporters would benefit from price stabilization only in two agricultural commodities: coffee and cocoa.
The case of three other agricultural commodities—cotton, jute, and sugar—where developing countries would also gain as exporters, rests on much weaker empirical ground, even though a priori considerations would tend to support the hypothesis that price fluctuations are prevalently generated by supply shifts. As importers, developing countries would stand to gain only from international price stabilization in wheat. They could, however, gain as producers from domestic price stabilization in maize and wool in addition to cocoa and coffee, where, as seen above, they would also gain from international price stabilization.
Most minerals, metals, and rubber—for which demand shifts are the main cause of price instability—seem to be poor candidates for international price stabilization if the purpose is to maximize the revenue and welfare of those developing countries which export these commodities. The only benefit that these countries would derive from stabilizing metal and rubber prices is that of greater revenue stability. However, given the probable consequent losses in income and welfare, export revenue stability could in these cases be better achieved by compensatory financing. Only if one accepts the premises that, from the global standpoint, gainers compensate for losers and price stability is superior to price instability—only then could the inclusion of some minerals and metals in a large-scale stabilization program for commodity prices be justified in order to achieve some kind of rough and ready automatic compensation between gainers and losers.
Results of analysis
Some important conclusions can be drawn from this analysis of the likely distribution of income and welfare gains from international price stabilization. First, the direct benefits accruing to developing countries from international price stabilization are likely to be modest, since the number of primary commodities where price stabilization can be assumed to be clearly beneficial to developing countries is quite limited. Coffee and cocoa accounted in 1973 for about 17 per cent of export earnings from major primary commodities produced by developing countries (excluding oil), and wheat accounted for about 15 per cent of total import expenditures of developing countries on primary commodities (excluding oil). Moreover, only coffee—as an export commodity—has general importance to the developing world. Cocoa has only regional importance as an export commodity for West Africa. However, cocoa is a very important source of income, employment, and foreign exchange for some of the poorest developing countries. Only if sugar, cotton, and jute could be included—on stronger empirical grounds than those found in this analysis—among the group of commodities for which international price stabilization can be assumed to be beneficial to developing countries, would the scope of international action in this field broaden enough to become more worthwhile for these poor developing countries.
The second conclusion is that international price stabilization in minerals and metals is not likely to benefit developing countries in terms of income and welfare. The empirical findings on the source of price instability for these products are largely in conformity with the a priori expectation that demand fluctuations—induced by changes in economic activities in developed countries—are the main cause of price fluctuations. International price stabilization in these commodities would benefit the developed countries that consume most of the minerals and metals exported by developing countries. To mitigate the adverse macroeconomic impact of fluctuations in the prices of minerals and metals on the economies of the developing countries that export these commodities, compensatory financing schemes, such as those of the Fund, appear to be the most appropriate instrument to use. Developing countries would still have a fairly wide array of domestic policy instruments to alleviate some of the most undesirable microeconomic effects of price fluctuations in their mineral and metal industries. By and large, the same considerations apply to rubber and sisal.
The third conclusion that emerges from this analysis is that while the welfare and income benefits of price stabilization at the international level are to a large extent independent of any specific stabilization instrument, the revenue stability benefits of price stabilization depend on the form of price stabilization. An international buffer stock could—at least in theory—completely stabilize export revenue. If other forms of price stabilization are chosen, revenue stabilization depends on the source of the price fluctuations and the price elasticities of demand and supply. For the two commodities (coffee and cocoa) where the developing countries stand to benefit as exporters from international price stabilization, the simultaneous achievement of the benefits of price and revenue stability does not seem to depend critically on the existence of an international buffer stock, since both demand for and supply of these commodities are rather price inelastic in the short and medium term.
Framework and limitations
These conclusions follow from the theoretical framework used for the analysis. The limitations of this framework, while not deemed to be too severe, need to be spelled out. First, the analysis of the benefits of price stabilization focused on the income and welfare gains of exporters (and importers) of primary commodities. Other potential benefits of price stability that can accrue to exporters—such as possible improvements in the long-term demand prospects for their products, reduction of the incentive to develop man-made substitutes, and greater bargaining strength of commodity sellers in international markets—were not considered. These other benefits could conceivably be quite important and could justify price stabilization even when welfare and income gains are likely to be negative for the exporting developing countries. Similarly, the question of the costs of international price stabilization was not dealt with in this article.
The analysis of welfare and income gains of commodity price stabilization was conducted by using a market model that, among other things, assumes instantaneous adjustments to price changes of quantities demanded and supplied. If alternative hypotheses—such as rational or adaptive expectations—are adopted in specifying the supply response to price changes, some of the conclusions regarding the distribution of the gains from price stability become less straight forward. It is extremely difficult, however, to decide on both theoretical and empirical grounds whether one type of price expectation hypothesis is superior to another in portraying what really happens in the various commodity markets. As a starting point, the analytical framework used in this analysis at least has the advantage of being simple and manageable.
A longer exposition on this subject is available in World Bank Staff Working Paper, “Commodity price stabilization and the developing world,” by the authors.