In their pursuit of economic development and, in some cases, to service sizable foreign debts, developing countries seek to strengthen export performance in traditional primary commodities in the short run while diversifying into more income-elastic export products in the long run. Yet a strategy of increasing the volume of traditional exports, particularly when other countries are attempting to do the same thing at the same time, may prove counterproductive if the main result of higher export volumes is lower commodity prices for all. Because measures to stimulate export production are often part of economic stabilization and adjustment programs, the possible repercussions of collective actions in world commodity markets are of concern to the International Monetary Fund.

Abstract

In their pursuit of economic development and, in some cases, to service sizable foreign debts, developing countries seek to strengthen export performance in traditional primary commodities in the short run while diversifying into more income-elastic export products in the long run. Yet a strategy of increasing the volume of traditional exports, particularly when other countries are attempting to do the same thing at the same time, may prove counterproductive if the main result of higher export volumes is lower commodity prices for all. Because measures to stimulate export production are often part of economic stabilization and adjustment programs, the possible repercussions of collective actions in world commodity markets are of concern to the International Monetary Fund.

In their pursuit of economic development and, in some cases, to service sizable foreign debts, developing countries seek to strengthen export performance in traditional primary commodities in the short run while diversifying into more income-elastic export products in the long run. Yet a strategy of increasing the volume of traditional exports, particularly when other countries are attempting to do the same thing at the same time, may prove counterproductive if the main result of higher export volumes is lower commodity prices for all. Because measures to stimulate export production are often part of economic stabilization and adjustment programs, the possible repercussions of collective actions in world commodity markets are of concern to the International Monetary Fund.

The Fund has addressed these concerns in a recent study (Goldstein (1986)), which examines the potential impact of collective exchange rate action on world commodity prices. This study identifies three important factors that determine the world price effects of multilateral exchange rate changes: (1) shares in world production. (2) degrees of concentration of production, and (3) price elasticities of supply and demand. The study evaluates these factors in the context of a general discussion of aggregated developing countries and commodities and concludes that the potential for deleterious collective effects is not great because production of many primary commodities is so widely dispersed that it would take simultaneous exchange rate action by many countries to achieve much of an impact on world supply. Moreover, even though world demand is usually quite inelastic, the relevant elasticities of supply are frequently low, so that supply shifts and consequent world price reductions are dampened, even if production is highly concentrated.

Although the Fund study is helpful, it lacks the detail necessary to be useful in many practical situations. To fill this need, this paper presents a simplified and readily transparent analytical framework that interrelates the key variables identified above, using a minimum of readily available information.

The Analytical Framework

Most world markets for non-oil primary commodities are essentially competitive. Although particular distortions may affect particular markets, these qualifications are matters of degree rather than kind. As with most other studies, the model formulated here therefore assumes that the market is cleared reasonably quickly through price adjustments.

The Model

Supply is determined by profit maximization on the part of producers, who respond to incentives provided by changes in relative producer prices. Demand is determined by utility maximization on the part of consumers, who respond to changes in relative consumer prices. Long-run factors that may affect supply—for example, technological change— are not explicitly part of the model, although implicitly they are incorporated into the supply elasticities used in the simulations. Similarly, long-run factors on the demand side—for example, population growth— have been incorporated into the model only implicitly through adjustment of relative trade shares in the simulations.

Trade flows between producing and consuming countries meet in the world market. Changes in international prices are assumed to be reflected fully in corresponding changes in domestic prices. This assumption of “full pass-through” need not necessarily imply equal corresponding levels initially, but it does imply that official producer pricing policy in exporting countries could not be changed to introduce further distortions.

With these introductory remarks, consider the following set of structural equations for supply and demand in a world commodity market:

Qs=(PESPS)a(1)
Qd=(PEDPD)b,(1)

where

Qs = quantity supplied

Qd = quantity demanded

P = world price of the commodity, in U.S. dollars

ES(ED) = exchange rate of the exporter (importer), in national currency units per U.S. dollar

PS(PD) = index of domestic prices of exporter (importer).

We assume that the world price is denominated (not determined) in U.S. dollars, since most world commodity prices are quoted in U.S. dollars. The equations above show supply to be a function of the real producer price, and demand to be a function of the real consumer price. When an exporter devalues its nominal exchange rate in relation to the dollar (ES), the real producer price—hence, the profitability of production—is raised to the extent that this change is not also fully reflected in the output prices of the nontraded sector or in the cost structure (proxied by PS) of the producer. This increased incentive to produce induces the reallocation of resources necessary to expand output. Similarly, when the world price (P) falls, the real consumer price in importing countries also falls (under the assumption of no change in the nominal exchange rate ED, and to the extent that the same fall is not fully reflected in the prices of nontraded substitutes or in the budget constraint—proxied by PD—of the consumer). This increased incentive to consume induces the necessary substitutions in order to absorb the increased output.

The reduced-form equations for percentage changes in world prices and quantities are1

Δp=aRbKab(3)
Δq=ab(KR)ab,(4)

where

R = Δps - Δes; or, the percentage change in the real exchange rate of the exporter in relation to the U.S. dollar

K = Δpd - Δes; or, the percentage change in the real exchange rate of the importer in relation to the U.S. dollar

a = elasticity of world supply in U.S. dollar terms

b = elasticity of world demand in U.S. dollar terms.

Note that exchange rate changes are specified in real terms—that is. changes in nominal rates corrected for changes in relative inflation levels.2 Except for this alteration, the model here is identical to the Ridler-Yandle model (1972), which relates world commodity prices, exchange rates, and exports.3

The changes in real exchange rates are interpreted as causing shifts in the supply and demand schedules when prices are expressed in U.S. dollars. This interpretation assumes that each exporter’s supply (or importer’s demand) schedule will shift to a degree directly proportional to its real exchange rate.4 Under the further assumption that the world supply (demand) elasticity is obtained as a weighted average of individual exporter (importer) components, in which the weights used are shares in world exports (imports), an estimate of the composite shift in the aggregate export supply (import demand) schedule for all countries is then obtained as an export-weighted (import-weighted) average of real exchange rate changes of individual countries. In equation (3), for example, this means that R (the shift factor for the world supply schedule) is an ex port-weigh ted average of real exchange rate changes of exporters, and K (the shift factor for the world demand schedule) is an import-weighted average of real exchange rate changes of importers,5

With the addition of elasticity estimates for a particular country, the foregoing estimates of that country’s import and export price changes can be used to derive estimates of changes in the volume and value of its external trade. Again the focus is on the supply side only:

Δqi=ai(ΔpRi)(5)
Δvi=Δp(1+ai)Riai,(6)

where

Δqi = the percentage change in export volume of country i

Δvi = the percentage change in export value of country i

ai = country i’s elasticity of export supply

Ri = Δpsi - Δesi; or, the percentage change in the real exchange rate of exporter i in relation to the U.S. dollar.

Some Supply-Side Properties

Because the objective is to estimate whether a single country, or a small group of countries, can benefit through increased export earnings from its major primary commodity after a devaluation, it is useful to explore the properties of equation (6) in two extreme cases, as well as the “crossover point” at which returns to devaluation shift from positive to negative values. In each case it is assumed that no shift in world demand occurs, so that the focus on supply-side effects can be maintained.

First, when the devaluing country is a small producer with an insignificant share of world exports, the first term in equation (6) disappears, so that the country always benefits by the maximum amount possible, with a percentage change in export value of6

Δvi=Riai,(7)

Second, at the opposite extreme, if all exporters were to devalue simultaneously (the group collectively being considered the ith, or monopoly, exporter), the change in the group’s equilibrium export value would be

Δvi=Ri(a+aib)(ab).(8)

Clearly the expansion of supply in this case does affect the world price. Whether the effect on export receipts is positive or negative depends on whether world demand is elastic or inelastic. If demand is elastic, the effect will be positive; if inelastic, it will be negative.

Third, the crossover point, or critical market share (θi*) for country i (assuming a single country or small group devalues and others do not), is

θi*=ai(ab)a(1+ai).(9)

With appropriate estimates of supply and demand elasticities, equation (9) can be used to evaluate the likelihood that particular countries could benefit from devaluation tn particular export markets. For example, using the first set of elasticity estimates (SR 1, MR 1, LR 1) in Table 1, the critical market shares for country 3 are 20.1 percent in the short run (SR) and 21.9 percent in both the medium run (MR) and long run (LR). Since country 3’s world export share is 16.3 percent (Table 2), it is likely that country 3 could benefit. Alternatively, using the second set of estimates (SR 2, MR 2, LR 2) in Table 1, the critical market shares for the commodity in the short, medium, and long runs would be 27 percent, 44 percent, and 56 percent, respectively. An “average” country (that is, one whose supply elasticity is equivalent to the world weighted average) whose market share is less (more) than these benchmarks could expect to gain (lose) export receipts from this commodity after a devaluation by itself alone.

Table 1.

Commodity Elasticity Assumptions

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Current and one-year lag.

Five to six years.

Nine years or more.

Weighted average using weights in Table 1.

Table 2.

Individual Country Trade Weights (Shares)

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Note: Trade weights are based on the average value of net exports during a recent period; those with less than 2 percent shares were deleted before renormalizing. Adjustments were made to incorporate estimates of projected shifts of production through the midpoint (if the projection period, and to distribute the share of the U.S.S.R. according to relative weights of the remaining countries.

A final case of interest is that in which multiple exporters, each with different supply elasticities, devalue simultaneously. For simplicity, assume that both exporters (countries 1 and 2) devalue by the same amount, then:

Table 3.

Expected Relative Gains or Losses, by Policy Regime and Elasticity of Export Supply

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A competitive policy means that the country participates in the devaluing group; a passive policy means that there is no change in the exchange rate as others devalue.

Δv1R1Δv2R2=(1c)(a2a1),(10)

where c = a/(a - b).

If both countries pursue competitive policies (that is, both devalue) and are gaining from devaluation (which, as noted, depends on the elasticity of demand), the country with the higher supply elasticity will gain more; if both countries arc losing, the country with a higher supply elasticity will lose less. Because it is intuitively clear that a country with a higher supply elasticity will lose more than one with a lower elasticity if both remain passive as the world price falls because of a third party’s actions, the expected pattern of relative gains and losses can be summarized as in Table 3.

II. Simulations

The problems in using the type of model outlined above for an applica-tion of the kind implemented here have been raised in previous studies.7 The simulations reported here were designed to minimize the risk that any of these problems would remain to cloud the conclusions. Two sets of supply and demand elasticities were used in the simulations; one set was obtained from the empirical literature, and the other was constructed on the basis of Fund staff estimates. The results reported here average those calculated from each set of elasticities, although the separate results did not differ much.8 Note that, although the model here uses elasticities of exports, the estimates available in the literature in general refer to production. The main variables intervening between production and export flows are domestic consumption and stocks. Domestic consumption is negligible for almost all of the types of commodities considered here, and the results can be thought of as implying constant stocks—as seems reasonable beyond the short run, when production and consumption tend to balance.

Table 4.

Baseline Commodity Price Projections

(Indices; in U.S. dollars)

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Note: The manufacturers’ price is the unit value of exports of manufactures (UVM) from industrial countries.

Deflated by the UVM.

The baseline scenario is presented in Table 4, and the results of the simulations (including the baseline case) are summarized in Table 5. The baseline senario shows a cumulative fall from the base year in the real commodity price of 25 percent in the short run (1-2 years), 29 percent in the medium run (5-6 years), and 24 percent in the long run (9-10 years).9

The initial set of supply scenarios included three runs (A-C in section II of Table 5) in which alternative sets of countries are assumed to devalue against the U.S. dollar by 3 percent a year over a decade: (A) country 2, accounting for 29.8 percent of world exports; (B) countries 2 and 3, with 46.1 percent; and (C) all exporters, with 100 percent.10 When country 2 alone devalues, the “small country” assumption holds, and the country benefits. In both the short run and medium run the rewards are relatively modest, but in the long run real export receipts from this commodity are raised by 7 percent over the baseline scenario. All other exporters suffer a decline in receipts that is somewhat greater than the fall in the world price because they all have positive supply elasticities— that is, the decline in price also elicits lower output.

When countries 2 and 3 devalue simultaneously (with it assumed that each acts alone), there eventually is a significant decline in the world price, although the net increase in world volume is small. Neither country benefits through the medium term, although country 2 benefits in the long run because of its much higher supply elasticity (see Table 1). The losses suffered by the other exporters exhibit the opposite tendency.11

Table 5.

Supply Simulations: Effects on World Market Prices and Volumes and Selected Countries’ Export Earnings from a Major Commodity

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The deflator is the export unit value of manufactures (UVM) of industrial countries, in U.S. dollars, from Table 4.

The simulation results shown here use the average of the two sets of elasticities for each period that are presented in Table 1.

Figures in parentheses are percentage world market shares, from Table 2.

The final run in this set of scenarios—when all exporters devalue simultaneously—illustrates how dramatically the world price can fall (by 15 percent in real terms) when world demand is inelastic, even with moderate increments in supply. All countries lose, of course, with the more supply-responsive among them losing less in the long run.

The fourth scenario (D) assumes that the developing country exporters tie their currencies to an industrial country’s currency (or to a basket of such currencies). Specifically, countries 1 and 2 remain linked to country 10, country 4 links to country 16, and all other exporters link to the U.S. dollar (the currency of country 17). When combined with the assumption of the baseline scenario that the major nondollar currencies appreciate against the U.S. dollar between the short and medium run,12 scenario D results in a slight net contraction of world output and a slight increase in the world price. Both of the countries aligning with country 10 lose because their export prices fall, which induces a reduction in their exports. Country 3, the only country in continent X that remains tied to the dollar, clearly gains the most.

The final set of scenarios consists of four parts (E-H in section II of Table 5); in each run country 6 is assumed to depreciate against the U.S. dollar by 15 percent in year 2, remaining at par at other times. In the first run (E), all other exporters are assumed to match country 6’s move in year 3. In the next run (F), only the exporters of continent X match country 6’s move; in the third run (G), only exporters outside of continent X match country 6. In the final run (H), all other countries remain passive. The comparative results suggest that the exporters of continent X lose least by remaining passive. If they and all others match country 6’s devaluation, additional supplies on world markets simply drive the world price lower. If the exporters outside of continent X do not go along, then an intermediate position is reached. In each case, the active countries with the most elastic production structures lose least.

III. Concluding Remarks

The simulation results of this exercise, based on estimates of the relevant elasticities and trade shares of an extant commodity market, suggest that the possibility of a country’s experiencing reduced export earnings from its major commodity export when it—and only one other large producer of the commodity—devalue is real. This result should not be generalized, however, because it depends on the presence of characteristics that are likely to cause such effects, such as large shares in world exports concentrated in only a couple of producers and a world market characterized by highly inelastic demand. Whether such effects are likely in other commodity markets is an empirical question that in most cases cannot be settled a priori.

Even if such deleterious effects seemed likely, however, this exercise is not an argument against devaluation. Devaluation is a general instrument that diverts resources into nontraditional export- and import-competing production, as well as into traditional export activity. The analysis docs, though, imply that, for some countries whose exports are dominated by a single commodity, or even by several traditional primary commodities, the evaluation of the effects of devaluation must take into account the likely policies of major competitors and the implications of these collective actions for world market prices. In this connection, it is hoped that the demonstration of the relatively simple methodology used in this paper will provide a useful framework for analysis.

REFERENCES

  • Chu, Ke-young, and Thomas K. Morrison, “World Non-Oil Primary Commodity Markets: A Medium-Term Framework of Analysis,” Staff Papers, International Monetary Fund (Washington), Vol. 33 (March 1986), pp. 13984.

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  • Feltenstein, Andrew, Morris Goldstein, and Susan M. Schadler, “A Multilateral Exchange Rate Model for Primary Producing Countries,” Staff Papers, International Monetary Fund (Washington), Vol. 26 (September 1979), pp. 54382.

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  • Gilbert, Christopher L., “Metals Market Efficiency in Relation to Forex and Financial Markets” (unpublished; Washington: World Bank, 1985).

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  • Goldstein, Morris, The Global Effects of Fund-Supported Adjustment Programs, Occasional Paper 42 (Washington: International Monetary Fund, 1986).

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  • International Monetary Fund, “Impact of the 1971 Currency Realignment on the Trade of Developing Countries” (unpublished; Washington: International Monetary Fund, 1972).

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  • Lebrun, Jean-Francois, Andre Sapir, and Alistair Ulph, “Imperfect Competition in Primary Commodity Markets: The Case of Copper,” Discussion Paper 8510 (Brussels: Centre d’Economie Mathematique et d’Econometrie, 1985).

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  • Ridler, Duncan, and Christopher Yandle, “A Simplified Method for Analyzing the Effects of Exchange Rate Changes on Exports of a Primary Commodity,” Staff Papers, International Monetary Fund (Washington), Vol. 19 (November 1972), pp. 55978.

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*

* Mr. Wattleworth, Senior Economist in the Research Department, is a graduate of the University of Illinois, Yale University, and the University of California, Berkeley. He wishes to thank his colleagues in the Fund for discussions that contributed substantially to the development of the paper.

1

The associated change in world value is the sum of the price and volume components. In the equations, lowercase letters indicate the natural logarithms of variables.

2

These real exchange rate changes are calculated bilaterally with the dollar and are specific to the commodity in question. This is a more narrowly defined concept than the conventionally defined real effective exchange rate (REER), which uses multilateral trade weights and currencies.

3

There is no doubt that Ridler and Yandle (1972) were thinking in terms of real exchange rate changes, but, given the low-inflation era in which they wrote, there must have seemed less need to couch the model explicitly in these terms.

4

Strictly speaking, this statement requires that the importer’s demand schedule, in terms of his own currency, remains unchanged; and that the exporter’s supply function is not affected by any cost change associated with the exchange rate change. For purposes of the analysis here, these are reasonable assumptions (International Monetary Fund (1972)).

5

Both the supply and demand equations could be altered to incorporate additional “shift factors,” such as income on the demand side, but such extensions are unnecessary for the purposes here. Similarly, the simple structure of the model abstracts from the elements that are not directly relevant to the first-round impact of the changes explored. For many primary products with long gestation lags (tree crops, mineral extraction), the first-round effects can easily take up to a decade. Various second-round effects—for example, through specification of “reaction functions”—could be hypothesized, but they are beyond the scope of this paper. See Chu and Morrison (1986) and Lebrun, Sapir, and Ulph (1985).

6

Devaluation in this formulation is a negative number; appreciation is a positive number (see footnote 10).

8

In other applications it might be useful to do a sensitivity analysis on the elasticity estimates if there is doubt about their reliability.

9

The baseline projections were part of a global projections exercise that produced a commodity price forecast over ten years that was consistent with a corresponding forecast for world prices of manufactures, a commonly used deflator, and with known assumptions regarding exchange rate changes, economic growth in industrial and developing countries, and other relevant variables affecting the supply and demand for commodities. The identities of the commodities and countries have been suppressed here, although all the data are actual.

10

Exchange rates are defined as units of national currency per dollar, and percentage changes are calculated as 100[(r1 - r2)/r2)], where r1 is the beginning exchange rate, and r2 is the final exchange rate. This method is equivalent to calculating percentage changes based on the value in the initial period and defining the exchange rate in terms of foreign currency units per unit of the nondollar national currency. This formulation was chosen so that appreciation of a currency is shown as a positive number, and depreciation, as a negative number. The year-on-year changes were computed as follows: for a 3 percent annual appreciation, r2 = (r1/1.03); for a 3 percent annual depreciation, r2 = (r1/0.97). The export share figures are taken from Table 2.

11

This is an example of the general result summarized in equation (10) and Table 3.

12

On the demand side, the baseline scenario assumes that the U.S. (country 17) dollar depreciates against other major currencies by 2.3 percent a year in real terms during the medium run; during other years, all major currencies remain unchanged. In terms of equation (3), for example, this implies that all Ki equal 9.5 percent in the medium run for all importers except the United States; correspondingly, the weighted-average outward shift in the world demand schedule (K) is equal to 6.4 percent by year 6. The weights are contained in Table 2. For suppliers, the baseline scenario assumes that country 4 depreciates by 1 percent a year against the U.S. dollar during all years, while all other exporters remain at par.