Barrels, Bushels & Bonds: How Commodity-Exporters Can Hedge Volatility

The prices of minerals, hydrocarbons, and agricultural commodities have been on a veritable roller coaster. Although commodity prices are always more variable than those for manufactured goods and services, commodity markets over the last five years have seen extraordinary volatility.

Countries that specialize in the export of oil, copper, iron ore, wheat, coffee, or other commodities have boomed. But they are highly vulnerable. Dollar commodity prices could plunge at any time, as a result of a new global recession, a hard landing in China, an increase in real interest rates in the United States, fluctuations in climate, or random sector-specific factors.

Countries that have outstanding debt in dollars or other foreign currencies are especially vulnerable. If their export revenues were to plunge relative to their debt-service obligations, the result could be crashes reminiscent of Latin America’s debt crisis in 1982 or the Asian and Russian currency crises of 1997-1998.

Many developing countries have made progress since the 1990’s in shifting from dollar-denominated debt toward foreign direct investment and other types of capital inflows, or in paying down their liabilities altogether. But some commodity exporters still seek ways to borrow that won’t expose them to excessive risk.

Commodity bonds may offer a neat way to circumvent these risks. Exporters of any particular commodity should issue debt that is denominated in terms of the price of that commodity, rather than in dollars or any other currency. Jamaica, for example, would issue alumina bonds; Nigeria would issue oil bonds; Sierra Leone would issue iron-ore bonds; and Mongolia would issue copper bonds. Investors would be able to buy Guatemala’s coffee bonds, Côte d’Ivoire’s cocoa bonds, Liberia’s rubber bonds, Mali’s cotton bonds; and Ghana’s gold bonds.

The advantage of such bonds is that in the event of a decline in the world price of the underlying commodity, the country’s debt-to-export ratio need not rise. The cost of debt service adjusts automatically, without the severe disruption that results from loss of confidence, crisis, debt restructuring, and so forth.

The idea is not new. (The oldest reference I know is Lessard & Williamson, 1985.) So, why has it not been tried before? When one asks finance ministers in commodity-exporting debtor countries, they frequently reply that they fear insufficient demand for commodity bonds.

That is a surprising proposition, given that commodity bonds have an obvious latent market, rooted in real economic fundamentals. After all, steel companies have an inherent need to hedge against fluctuations in the price of iron ore, just as airlines and utilities have an inherent need to hedge against fluctuations in the price of oil. Each of these commodities is an important input for major corporations. Surely there is at least as much natural demand for commodity bonds as there is for credit-default swaps and some of the bizarrely complicated derivatives that are currently traded!

It takes liquidity to make a market successful, and it can be difficult to get a new one started until it achieves a certain critical mass. The problem may be that there are not many investors who want to take a long position on oil and Nigerian credit risk simultaneously.

A multilateral agency such as the World Bank could play a critical role in launching a market in commodity bonds. The fit would be particularly good in those countries where the Bank is already lending money.

Here is how it would work. Instead of denominating a loan to Nigeria in terms of dollars, the Bank would denominate it in terms of the price of oil; it would then turn around and lay off its exposure to the world oil price by issuing that same quantity of bonds denominated in oil. If the Bank lends to multiple oil-exporting countries, the market for oil bonds that it creates would be that much larger and more liquid. It can serve an additional important pooling function in cases where there are different grades or varieties of the product (as with oil or coffee), and where prices can diverge enough to make an important difference to the exporters. The Bank could link the bond it issues to an oil price index, a weighted average of various product grades.

An alternative for some commodity exporters is to hedge their risk by selling on the futures market. But an important disadvantage of derivatives is their short maturity. A West African country with newly discovered oil reserves needs to finance exploration, drilling, and pipeline construction, which means that it needs to hedge at a time horizon of 10-20 years, not 90 days.

Another disadvantage of derivatives is that they require a high degree of sophistication –both technical and political. In the event of an increase in a commodity’s price, a finance minister who has done a perfect job ex ante of hedging export-price risk on the futures market will suddenly find himself accused ex post of having gambled away the national patrimony. This principal-agent problem is much diminished in the case of commodity bonds.

If the international financial wizards can get together and act on this idea now, commodity exporters might be able to avoid calamity the next time the world price of their product takes a plunge. The World Bank should take up the cause.

Barrels, Bushels & Bonds: How Commodity-Exporters Can Hedge Volatility

The prices of minerals, hydrocarbons, and agricultural commodities have been on a veritable roller coaster. Although commodity prices are always more variable than those for manufactured goods and services, commodity markets over the last five years have seen extraordinary volatility.

Countries that specialize in the export of oil, copper, iron ore, wheat, coffee, or other commodities have boomed.  But they are highly vulnerable. Dollar commodity prices could plunge at any time, as a result of a new global recession, a hard landing in China, an increase in real interest rates in the United States, fluctuations in climate, or random sector-specific factors.

Countries that have outstanding debt in dollars or other foreign currencies are especially vulnerable. If their export revenues were to plunge relative to their debt-service obligations, the result could be crashes reminiscent of Latin America’s debt crisis in 1982 or the Asian and Russian currency crises of 1997-1998.

Many developing countries have made progress since the 1990’s in shifting from dollar-denominated debt toward foreign direct investment and other types of capital inflows, or in paying down their liabilities altogether. But some commodity exporters still seek ways to borrow that won’t expose them to excessive risk.

Commodity bonds may offer a neat way to circumvent these risks. Exporters of any particular commodity should issue debt that is denominated in terms of the price of that commodity, rather than in dollars or any other currency. Jamaica, for example, would issue alumina bonds; Nigeria would issue oil bonds; Sierra Leone would issue iron-ore bonds; and Mongolia would issue copper bonds. Investors would be able to buy Guatemala’s coffee bonds, Côte d’Ivoire’s cocoa bonds, Liberia’s rubber bonds, Mali’s cotton bonds; and Ghana’s gold bonds.

The advantage of such bonds is that in the event of a decline in the world price of the underlying commodity, the country’s debt-to-export ratio need not rise. The cost of debt service adjusts automatically, without the severe disruption that results from loss of confidence, crisis, debt restructuring, and so forth.

The idea is not new. (The oldest reference I know is Lessard & Williamson, 1985.)  So, why has it not been tried before? When one asks finance ministers in commodity-exporting debtor countries, they frequently reply that they fear insufficient demand for commodity bonds.

That is a surprising proposition, given that commodity bonds have an obvious latent market, rooted in real economic fundamentals. After all, steel companies have an inherent need to hedge against fluctuations in the price of iron ore, just as airlines and utilities have an inherent need to hedge against fluctuations in the price of oil.  Each of these commodities is an important input for major corporations. Surely there is at least as much natural demand for commodity bonds as there is for credit-default swaps and some of the bizarrely complicated derivatives that are currently traded!

It takes liquidity to make a market successful, and it can be difficult to get a new one started until it achieves a certain critical mass. The problem may be that there are not many investors who want to take a long position on oil and Nigerian credit risk simultaneously.

A multilateral agency such as the World Bank could play a critical role in launching a market in commodity bonds. The fit would be particularly good in those countries where the Bank is already lending money.

Here is how it would work. Instead of denominating a loan to Nigeria in terms of dollars, the Bank would denominate it in terms of the price of oil; it would then turn around and lay off its exposure to the world oil price by issuing that same quantity of bonds denominated in oil. If the Bank lends to multiple oil-exporting countries, the market for oil bonds that it creates would be that much larger and more liquid. It can serve an additional important pooling function in cases where there are different grades or varieties of the product (as with oil or coffee), and where prices can diverge enough to make an important difference to the exporters.  The Bank could link the bond it issues to an oil price index, a weighted average of various product grades.

An alternative for some commodity exporters is to hedge their risk by selling on the futures market. But an important disadvantage of derivatives is their short maturity. A West African country with newly discovered oil reserves needs to finance exploration, drilling, and pipeline construction, which means that it needs to hedge at a time horizon of 10-20 years, not 90 days.

Another disadvantage of derivatives is that they require a high degree of sophistication –both technical and political. In the event of an increase in a commodity’s price, a finance minister who has done a perfect job ex ante of hedging export-price risk on the futures market will suddenly find himself accused ex post of having gambled away the national patrimony. This principal-agent problem is much diminished in the case of commodity bonds.

If the international financial wizards can get together and act on this idea now, commodity exporters might be able to avoid calamity the next time the world price of their product takes a plunge.  The World Bank should take up the cause.

[This column originally appeared via Project Syndicate, which has the copyright.  Comments may be posted there.]

The Rise of the Renminbi as International Currency: Historical Precedents

All of a sudden, the renminbi is being touted as the next big international currency. Just in the last year or two, the Chinese currency has begun to internationalize along a number of dimensions. RMB bank desposits are now available in Hong Kong. A RMB bond market has grown rapidly there as well, with the issuers including major multinationals such as McDonald’s. Some of China’s international trade is now invoiced in the currency. Foreign central banks have been able to hold RMB since August 2010, with Malaysia going first.

Some are now claiming that the renminbi could overtake the dollar for the number one slot in the international currency rankings within a decade (especially Subramanian 2011a, p.19; 2011b). The basis of this prediction is, first, the likelihood that the Chinese economy will surpass the US economy in size and, second, the historical precedent when the dollar overtook the pound sterling as the number one international currency during the period after World War I.

It used to be thought that international currency status was subject to much inertia (e.g., Krugman, 1984). There was said to have been a long lag between the date when the US economy had passed the UK economy with respect to size (1872, by the criterion of GNP) and the time when the dollar had passed the pound (1946, by the criterion of shares in central banks’ holdings of reserves).

The “new view,” represented in particular by Eichengreen (2011) and Eichengreen and Flandreau (2010), is that the lag was in fact rather short. It took until World War I for the dollar to fulfill the criteria of an international currency. Furthermore, the date when the dollar is said to have challenged the pound in importance has now been moved up to the mid-1920s. The first point is right. If trade is the measure of size, the US first caught up with the UK during World War I. The US did not even have a permanent central bank until 1913. The other important criteria came soon thereafter: creditor status for the country; the perceived prospects for the currency to remain strong in value; and deep, liquid, open financial markets. (I have discussed the criteria in earlier papers. Chinn and Frankel, 2007, evaluate them econometrically and give further references.) The second point seems a matter of whether or not one wants to distinguish between the concept of “coming to rival” / “catching up with” the pound (1920s) versus the phenomenon of definitively “pulling ahead” / “displacing” the pound (1945). Under either interpretation, the dollar’s initial rise as an international currency was indeed rapid, once the conditions were in place.

The dollar is one of three national currencies to have attained international status during the 20th century. The other two were the yen and the mark, which became major international currencies after the breakup of the Bretton Woods system in 1971-73. (The euro, of course, did so after 1999.) In the early 1990s, both were spoken of as potential rivals of the dollar for the number one slot. It is easy to forget it now, because Japan’s relative role has diminished since then and the mark has been superseded. In retrospect, the two currencies’ shares in central bank reserves peaked as the 1990s began.

The current RMB phenomenon differs in an interesting way from the historical circumstances of the rise of the three earlier currencies. The Chinese government is actively promoting the international use of its currency. Neither Germany nor Japan, nor even the US, did that, at least not at first. In all three cases, export interests, who stood to lose competitiveness if international demand for the currency were to rise, were much stronger than the financial sector, which might have supported internationalization. One would expect the same fears of a stronger currency and its effects on manufacturing exports to dominate the calculations in China.

In the case of the mark and yen after 1973, internationalization came despite the reluctance of the German and Japanese governments. In the case of the United States after 1914, a tiny elite promoted internationalization of the dollar despite the indifference or hostility to such a project in the nation at large. These individuals, led by Benjamin Strong, the first president of the New York Fed, were the same ones who had conspired in 1910 to establish the Federal Reserve in the first place.

It is not yet clear that China’s new enthusiasm for internationalizing its currency includes a willingness to end financial repression in the domestic financial system, remove cross-border capital controls, and allow the RMB to appreciate, thus helping to shift the economy away from its export-dependence. Perhaps a small elite will be able to accomplish these things, in the way that Strong did a century earlier. But so far the government is only promoting international use of the RMB offshore, walled off from the domestic financial system. That will not be enough to do it.

[This RIETI perspectives note summarizes the argument in “Historical Precedents for the Internationalization of the RMB,” a paper that I have written for a workshop directed by Sebastian Mallaby, for the Council on Foreign Relations and the China Development Research Foundation.]

Comments can be posted at the version on the Vox site or Seeking Alpha.

References

Chinn, Menzie, and Jeffrey Frankel , 2007, “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” in G7 Current Account Imbalances: Sustainability and Adjustment, edited by Richard Clarida (University of Chicago Press).

Eichengreen, Barry, 2011, Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System (Oxford University Press).

Eichengreen, Barry, and Marc Flandreau, 2010, “The Federal Reserve, the Bank of England and the Rise of the Dollar as an International Currency, 1914-39,” BIS WP no. 328, Nov.

Eichengreen, Barry, and Jeffrey Frankel, 1996, “The SDR, Reserve Currencies, and the Future of the International Monetary System” in The Future of the SDR in Light of Changes in the International Financial System, edited by M.Mussa, J.Boughton, and P.Isard (International Monetary Fund).

Krugman, Paul, 1984, “The International Role of the Dollar: Theory and Prospect,” in Exchange Rate Theory and Practice, edited by J.Bilson and R.Marston (University of Chicago Press), 261-78.

Subramanian, Arvind, 2011a, “Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition,” (Petersen Institute for International Economics), September.

Subramanian, Arvind, 2011b , Eclipse: Living in the Shadow of China’s Economic Dominance (Petersen Institute for International Economics), September.

The Rise of the Renminbi as International Currency: Historical Precedents

All of a sudden, the renminbi is being touted as the next big international currency.   Just in the last year or two, the Chinese currency has begun to internationalize along a number of dimensions.   RMB bank desposits are now available in Hong Kong.  A RMB bond market has grown rapidly there as well, with the issuers including major multinationals such as McDonald’s.   Some of China’s international trade is now invoiced in the currency.  Foreign central banks have been able to hold RMB since August 2010, with Malaysia going first.

Some are now claiming that the renminbi could overtake the dollar for the number one slot in the international currency rankings within a decade (especially Subramanian 2011a, p.19; 2011b).   The basis of this prediction is, first, the likelihood that the Chinese economy will surpass the US economy in size and, second, the historical precedent when the dollar overtook the pound sterling as the number one international currency during the period after World War I.

It used to be thought that international currency status was subject to much inertia (e.g., Krugman, 1984).  There was said to have been a long lag between the date when the US economy had passed the UK economy with respect to size (1872, by the criterion of GNP) and the time when the dollar had passed the pound (1946, by the criterion of shares in central banks’ holdings of reserves).

The “new view,” represented in particular by Eichengreen (2011) and Eichengreen and Flandreau (2010), is that the lag was in fact rather short.  It took until World War I for the dollar to fulfill the criteria of an international currency.  Furthermore, the date when the dollar is said to have challenged the pound in importance has now been moved up to the mid-1920s.   The first point is right. If trade is the measure of size, the US first caught up with the UK during World War I.  The US did not even have a permanent central bank until 1913.  The other important criteria came soon thereafter:  creditor status for the country; the perceived prospects for the currency to remain strong in value; and deep, liquid, open financial markets.  (I have discussed the criteria in earlier papers.  Chinn and Frankel, 2007, evaluate them econometrically and give further references.)  The second point seems a matter of whether or not one wants to distinguish between the concept of “coming to rival” / “catching up with”  the pound (1920s) versus the phenomenon of definitively “pulling ahead” / “displacing” the pound (1945).  Under either interpretation, the dollar’s initial rise as an international currency was indeed rapid, once the conditions were in place.

The dollar is one of three national currencies to have attained international status during the 20th century.  The other two were the yen and the mark, which became major international currencies after the breakup of the Bretton Woods system in 1971-73.  (The euro, of course, did so after 1999.)  In the early 1990s, both were spoken of as potential rivals of the dollar for the number one slot.  It is easy to forget it now, because Japan’s relative role has diminished since then and the mark has been superseded.  In retrospect, the two currencies’ shares in central bank reserves peaked as the 1990s began.

The current RMB phenomenon differs in an interesting way from the historical circumstances of the rise of the three earlier currencies.  The Chinese government is actively promoting the international use of its currency.   Neither Germany nor Japan, nor even the US, did that, at least not at first.   In all three cases, export interests, who stood to lose competitiveness if international demand for the currency were to rise, were much stronger than the financial sector, which might have supported internationalization.  One would expect the same fears of a stronger currency and its effects on manufacturing exports to dominate the calculations in China.

In the case of the mark and yen after 1973, internationalization came despite the reluctance of the German and Japanese governments.  In the case of the United States after 1914, a tiny elite promoted internationalization of the dollar despite the indifference or hostility to such a project in the nation at large.  These individuals, led by Benjamin Strong, the first president of the New York Fed, were the same ones who had conspired in 1910 to establish the Federal Reserve in the first place.

It is not yet clear that China’s new enthusiasm for internationalizing its currency includes a willingness to end financial repression in the domestic financial system, remove cross-border capital controls, and allow the RMB to appreciate, thus helping to shift the economy away from its export-dependence.  Perhaps a small elite will be able to accomplish these things, in the way that Strong did a century earlier.  But so far the government is only promoting international use of the RMB offshore, walled off from the domestic financial system.  That will not be enough to do it.

[This RIETI perspectives note summarizes the argument in “Historical Precedents for the Internationalization of the RMB,” a paper that I have written for a workshop directed by Sebastian Mallaby, for the Council on Foreign Relations and the China Development Research Foundation.]

Comments can be posted at the version on the Vox site or Seeking Alpha.

References

Chinn, Menzie, and Jeffrey Frankel , 2007, “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” in  G7 Current Account Imbalances: Sustainability and Adjustment,edited by Richard Clarida (University of Chicago Press).

Eichengreen, Barry, 2011, Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System (Oxford University Press).

Eichengreen, Barry, and Marc Flandreau, 2010, “The Federal Reserve, the Bank of England and the Rise of the Dollar as an International Currency, 1914-39,” BIS WP no. 328, Nov.

Eichengreen, Barry, and Jeffrey Frankel, 1996, “The SDR, Reserve Currencies, and the Future of the International Monetary System” in The Future of the SDR in Light of Changes in the International Financial System, edited by M.Mussa, J.Boughton, and P.Isard (International Monetary Fund).

Krugman, Paul, 1984, “The International Role of the Dollar: Theory and Prospect,” in Exchange Rate Theory and Practice, edited by J.Bilson and R.Marston (University of Chicago Press), 261-78.

Subramanian, Arvind, 2011a, “Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition,” (Petersen Institute for International Economics), September.

Subramanian, Arvind, 2011b , Eclipse: Living in the Shadow of China’s Economic Dominance (Petersen Institute for International Economics), September.