Heterogeneous effects of commodity shocks on vulnerability index: Trade size..... Abstract 300 words or less: This study investigates the impact of commodity terms of trade on the Econo
Introduction
Commodity price fluctuations have a profound impact on the economic stability and development of nations reliant on commodity exports The volatility of these prices creates significant income fluctuations, leading to windfall gains and losses This vulnerability is exacerbated by globalization and interconnectedness The article's research question explores whether price fluctuations exacerbate or mitigate economic instability and seeks solutions to enhance stability amidst expanding global trade.
The Commodity Terms of Trade (CTOT) is a vital metric for understanding a nation's sensitivity to commodity price fluctuations, gauging income gains and losses from global commodity price shifts (Krugman & Obstfeld, 2009; Sokhanvar et al., 2023) CTOT analysis is crucial for deciphering economic vulnerability in commodity-dependent nations (Baffes & Kabundi, 2023; Gruss & Kebhaj, 2019) This study unpacks the economic effects of CTOT, engaging in the ongoing debate between proponents of unrestricted global trade (Austrian and neoclassical economists) and advocates for government intervention to counter systemic global shocks (neo-Keynesian economists) (Freidman, 2005; Hayek & Caldwell, 2014; Rickards, 2012; Collins, 2017).
This study aims to bridge the existing gap in the academic literature by investigating how CTOT and other commodity-related indices, in conjunction with country-specific factors, collectively contribute to economic vulnerability Through this analysis, we seek to shed light on the intricate interplay between commodity dependence, price fluctuations, and a country’s overall susceptibility to economic shocks The outcomes of this research hold substantial policy implications, aiding governments and international organizations in formulating strategies to enhance the resilience and sustainability of economies dependent on commodity exports The current work, thus, has two primary objectives: first, to explore the intricate relationship between international trade shocks and economic uncertainty, and second, to delineate the diverse effects of these shocks on various sectors of the economy Besides, it also aimes to scrutinize the role of government policies in alleviating the adverse consequences of such shocks while simultaneously examining the differential impact experienced by different level of government effectiveness and trade sizes
The remaining part of the study is outlined as follows Section 2 presents a literature review, and Section 3 describes the empirical estimation model and data requirements Section 4 presents the research findings, while Section 5 discusses and suggests some policy implications.
Literature Review
Economic vulnerability refers to the probability that the economic progress of a nation may be impeded by external unforeseen occurrences, commonly referred to as external shocks (Guillaumont, 2008, 2014) Since the 1990s, there has been a growing interest in assessing the economic vulnerability of developing countries In 2000, economic vulnerability, as measured by the Economic Vulnerability Index (EVI), became an additional criterion alongside GDP per capita and human capital for identifying least developed countries Subsequently, the EVI underwent revisions for the 2006 and 2009 assessments proposed by the United Nations Committee for Development Policy (UNCDP) to identify Least Developed Countries
The commodity terms-of-trade index quantifies the relationship between a nation’s export and import prices, typically represented as an index figure This index is a gauge for fluctuations in the comparative prices of a nation’s exports and imports An uptick in the index signifies an increase in a nation’s export prices relative to its import prices, whereas a downturn in the index indicates a decline in a nation’s export prices vis-à-vis its import prices Consequently, the commodity terms-of-trade index holds significance as an indicator of a nation’s economic performance and capability to leverage international trade for economic gain (Gruss, 2014; Gruss
Various studies have employed commodity prices to assess exogenous shocks in terms of trade or the impact of commodity price fluctuations on macroeconomic outcomes This approach has been prevalent in research since Deaton & Miller (1995) and is also evident in Gruss & Kebhaj's (2019) work.
The framework proposed by Alquist et al (2020) delineates the factor structure underlying commodity prices, segregating exogenous forces, commonly called “shocks,” into two distinct categories The initial category encompasses shocks directly influencing commodities’ supply and demand dynamics These shocks, even in the absence of broader changes in aggregate income, can impact commodity prices, albeit they may also precipitate general-equilibrium shifts in aggregate income, consequently exerting additional indirect effects on commodity prices The second category comprises shocks that indirectly influence commodity prices through their repercussions on aggregate output These indirect effects manifest through two primary channels First, the conventional demand channel operates whereby heightened aggregate economic activity prompts increased demand for commodities employed in final goods production, thereby elevating commodity prices universally Second, the supply-side channel, underpinned by income effects, manifests when heightened aggregate income dissuades agents from supplying inputs requisite for commodity production, consequently propelling commodity prices upward Both channels engender a positive correlation among commodity prices (Agénor et al., 2000; Blattman et al., 2007; Raddatz, 2007)
Both of these mechanisms strongly align with the theory of aggregate demand, where the role of government remains a subject of ongoing debate between Neo-Keynesian and Neo- classical/Austrian economics Neo-Keynesians frequently advocate for government intervention to alleviate vulnerabilities in international trade by implementing policies to stabilize economies and foster equitable growth (Collins, 2017) Through proactive fiscal and monetary measures, governments can offset fluctuations in demand and address trade imbalances, thereby diminishing the susceptibility of domestic industries to external shocks (Krugman, 1995; Krugman & Obstfeld,
2009) Moreover, strategic trade policies, such as subsidies for industries with the potential for increasing returns to scale, can enhance global market competitiveness and bolster domestic producers’ resilience against foreign competition (Bhagwati, 1988) In contrast, Austrian economists (e.g., Hayek & Caldwell, 2014) criticize the long-term impacts of interventions for disrupting market signals (investment or consumption opportunities), altering behavior and reducing economic efficiency Similarly, Freidman (2005) contends that government interventions and the creation of additional barriers to international trade only lead to diminished prosperity among nations, increasing economic stability Furthermore, many discussions emphasize the political benefits of increased trade, contributing to greater cohesion and reduced economic instability However, real-world observations in this century (e.g., Brexit or the Russia-Ukraine conflict) have cast significant doubt on these arguments
Regarding mechanisms, fluctuations in commodity prices can positively impact economic stability as follows First, in economies heavily reliant on commodity exports, such fluctuations can lead to increased revenues during periods of price booms, thereby stimulating economic growth and investment (Deaton, 1992) This revenue surge can engender a sense of optimism and confidence among businesses and consumers, potentially bolstering economic activity (Kilian,
2008) Similarly, Moreira (2016) and Papyrakis & Gerlagh (2006) assert that during commodity boom periods, the expansion in output and the exploitation of higher prices by producers result in more significant gains, stimulating overall economic activity as businesses expand operations, invest in new projects, and increase employment opportunities Notably, the augmented revenues derived from commodities can enhance government revenues through taxes and royalties, thereby providing additional funds for public expenditure and infrastructure development, further fostering economic growth (Arezki & Brückner, 2012a, 2012b) These discussions align with broader considerations regarding the influence of international trade on the global economy through aggregate demand Indeed, Feldkircher and Huber (2016) explore the dynamics of economic shocks and their effects on developed and developing nations Their study employs a Bayesian global vector autoregressive model to examine the international spillovers of expansionary US aggregate demand and supply shocks, as well as a contractionary US monetary policy shock, underscoring the importance of addressing uncertainty in variable selection
Second, volatility in commodity prices can act as a catalyst for diversification and innovation in economies reliant on commodities as governmental entities and businesses endeavor to mitigate their exposure to price fluctuations by exploring alternative revenue streams (Baffes & Nagle, 2022) Recent empirical evidence from oil-dependent countries further supports this assertion (Adams et al., 2019; Havranek et al., 2016) Third, within financial markets, fluctuations in commodity prices offer opportunities for investors to capitalize on price movements through trading and speculation, enhancing market liquidity and efficiency Indeed, as Gilbert (2010, p
43) contends, “investors are motivated to improve the risk-return characteristics of their overall portfolios, in which commodities will typically form a small component, rather than in the risk- return properties of the commodity sub-portfolio or its individual commodity components.” It should be noted that the increase in risk-bearing investments is accompanied by developing more diverse and high-quality financial insurance services, which can alleviate economic instability (Bonnier, 2021)
Commodity price fluctuations have detrimental effects on economic uncertainty due to their widespread impact across industries These fluctuations disrupt production processes and supply chains, resulting in inefficiencies and higher operational costs for businesses This uncertainty leads to deferred investment decisions and reduced production, slowing overall economic growth Moreover, policymakers face challenges in controlling inflation and maintaining price stability amidst commodity price volatility.
The decline in oil prices negatively affects investor sentiment and may lead to volatility in financial markets (Baffes et al., 2015) Commodity-dependent nations face increased vulnerability due to external shocks and economic instability (Briguglio, 2016; Trửster and Kỹblbửck, 2020) The ability to utilize commodity windfalls for public expenditure is contingent on institutional quality and development level (Arezki & Brückner, 2012a, 2012b) International trade significantly affects real interest rates (Akram, 2009; Akyüz, 2020), influencing investment behavior and aggregate demand (Aizenman et al., 2012).
In summary, the literature reviewed thus far highlights several key points First, within the framework of aggregate demand analysis, it is evident that fluctuations in international commodity prices affect open economies’ stability through government spending changes (Collins, 2017) Typically, countries pursue a strategy to mitigate business cycle fluctuations (Céspedes & Velasco,
2012) and achieve economic stability if the government operates efficiently However, the appropriateness of intervention at various levels remains a contentious topic, unresolved between neoclassical economists and neo-Keynesians, necessitating further empirical evidence to confirm the validity of theories (Hayek & Caldwell, 2014; Krugman & Obstfeld, 2009) Second, the impacts of commodity shocks on economic stability involve various explanatory mechanisms (both direct and indirect), lacking consensus on the topic For instance, is the shock impact consistent between exports and imports? Alternatively, does a price increase in export goods compensate for a corresponding price decrease in imports? Also, measurements of commodity shocks lack consensus on several aspects, leading to mixed empirical findings across multiple domains (Gruss & Kebhaj, 2019) Therefore, this study aims to provide additional empirical evidence to shed light on understanding the direct impact mechanisms of the nexus under consideration through the government’s role in adjusting aggregate demand
The fundamental model is adapted from the prior research conducted by Arezki and Bruckner
𝑌 𝑖𝑡 = 𝛼 𝑖 + 𝜆𝑡 + 𝛽 1 𝐶𝑇𝑜𝑇 𝑖𝑡−𝑠 + 𝑍𝜂′ + 𝑢 𝑖𝑡 (1) where 𝑌 𝑖𝑡 denotes the economic uncertainty of country 𝑖 in year 𝑡 The Economic Vulnerability Index, is used in this study, is a multifaceted metric designed to assess the susceptibility of countries, particularly smaller and developing nations, to a variety of economic shocks and challenges, incorporating factors such as economic diversification, the size of the economy, external shock exposure, and vulnerability to natural disasters, with the objective of pinpointing nations at higher risk of economic instability and disruptions, thus equipping policymakers with the information needed to allocate resources and enact tailored strategies to enhance economic resilience (Dataset available at: https://ferdi.fr/)
Data & Methodology Error! Bookmark not defined 4 Results
Dynamics in the relationship
The study aims to ascertain the time lag in the impact of commodity windfall on economic uncertainty in the empirical model (i.e., setting the value of s in equation (1)) Figure [3] illustrates the impulse response of commodity shocks to EVI, utilizing an intuitive technique from Jordà
Commodity windfalls cause a surge in economic value (EVI) during the shock year, peaking a year later This aligns with previous findings that show commodity shocks lead to reduced public debt, increased government revenue, a stronger effective exchange rate, higher financial market volatility, and even crises This one-year lag is often attributed to a delay in countries' policy adjustments after global shocks, such as changes in exchange rates, interest rates, or government spending.
The prevailing theory supporting these findings can be traced back to (neo) Keynesian economists; for example, Kose and Riezman (2001, p 55) describe shocks affecting the economic condition as follows: “trade shocks account for roughly half of economic fluctuations in aggregate output”, thus government intervention in response to these shocks is deemed necessary and achieved through changes in aggregate demand Similarly, evidence is found in developing countries (Agénor et al., 2000; Blattman et al., 2007; Raddatz, 2007) It should be noted that Austrian School economists and neo-classical economists criticize this deep government intervention as the cause of market signal disturbances and long-term operational inefficiencies (Hayek & Caldwell, 2014; Rothbard, 2009), while recent economists advocate for a perspective on the balance of power between the state and society (Acemoglu & Robinson, 2019)
Figure 3 Impulse response of commodity windfall on EVI
Main results
The findings presented in Table 2 illustrate the impact of commodity terms of trade, as measured by the net export price index, on changes in EVI The estimated coefficients (0.010) in the model are statistically significant, as indicated in column [1], suggesting a positive correlation between the benefits derived from trade exchange (i.e., through increases in export prices or decreases in import prices) and economic stability In column [2], additional control for government expenditure increases the coefficient from 0.010 to 0.012 Since government spending enhances economic stability, the subsequent negative correlation between commodity windfall and government expenditure suggests that policies aim to reduce business cycle fluctuations; specifically, during a commodity boom period, countries often decline government spending to prevent overheating of the economy, and conversely during commodity bust periods (Céspedes & Velasco, 2012) Thus, when the channel of government spending on final consumption is shut down, the impact of commodity shock on EVI is boosted (refer to Appendix [2]) In column [3], after controlling for the real interest rate, the coefficient also increases from 0.012 to 0.021 This confirms the transmission channel of commodity shock to economic instability through an increase in the real interest rate (Akram, 2009; Akyüz, 2020), given that an increase in the domestic real interest rate diminishes economic stability (Rickards, 2012) The research findings remain robust after controlling for factors that may be correlated with both commodity shock and EVI, including FDI scale (Jardet et al., 2023; Nguyen & Lee, 2021), GDP size (Moore, 2017), scale of international trade (Falvey et al., 2012), and state capacity (e.g., the degree of corruption control and saving in the economy) (Ivlevs & Hinks, 2015; Pitelis, 2004) in column [4]
Table [3] presents the partial effects of changes in exported and imported commodity prices on changes in EVI The results verify consistent findings indicating that the gains (losses) in international trade due to changes in commodity prices for exports and imports enhance (reduce) the economy’s stability This can also be observed in Venezuela, where there is a heavy reliance on imported food, while the primary exports are based on crude oil (Global Agricultural Information Network (GAIN), 2023; Hammond, 2011; Su et al., 2020) The variation in coefficients across the columns within Table [3] is consistent with the expectations of previous studies and aligns with the findings in Table [2]
Table 2 Regression of (net exported prices) commodity shock on the EVI
Dependent variable ∆Economic Vulnerability Index
(Net Exported Prices) Commodity Shock t-1 0.010*** 0.012*** 0.021*** 0.031***
(0.004) (0.004) (0.006) (0.007) Share of government final consumption expenditure t (GFCE) 0.019** 0.039*** 0.048***
Share of foreign direct investment t -0.003
GDP on logarithm (PPP, $US) t -0.441
Country dummies Yes Yes Yes Yes
Year dummies Yes Yes Yes Yes
Source: Authors Notes: Standard errors are indicated in parentheses: *** denotes significance at the 0.01 level,
** at the 0.05 level, and * at the 0.1 level
Table 3 Regression of commodity shocks on the EVI: Exported and imported prices
Dependent variable ∆Economic Vulnerability Index
Share of foreign direct investment t -0.005 -0.005
GDP on logarithm (PPP, $US) t -0.268 -0.299
Country dummies Yes Yes Yes Yes Yes Yes
Year dummies Yes Yes Yes Yes Yes Yes
Source: Authors Notes: Standard errors are indicated in parentheses: *** denotes significance at the 0.01 level,
** at the 0.05 level, and * at the 0.1 level
Table [4] analyses the impact of commodity trade on the fluctuations of EVI components: the overall shock index from column [1] to [3], the trade shock index from column [4] to [6], and the agricultural shock index from column [7] to [9] The results again affirm the relationship’s robustness, with the highest coefficient observed with the trade shock subindex (0.074 in column [6]) The trade shock index is measured to reflect highly variable export earnings causing fluctuations in production, employment, and the availability of foreign exchange Table 5 presents the results with two components: (i) exposure index and (ii) economic structure subindex, which reflect the degrees of concentration of goods and services in a country’s international trade The results are not statistically significant after controlling for government spending and other factors, reflecting the adequacy of the data given that no theory supports this perspective
Dependent variables ∆Shock index ∆Trade shock index ∆Agricultural shock index
Country dummies Yes Yes Yes Yes Yes Yes Yes Yes Yes
Year dummies Yes Yes Yes Yes Yes Yes Yes Yes Yes
Source: Authors Notes: Standard errors are indicated in parentheses: *** denotes significance at the 0.01 level,
** at the 0.05 level, and * at the 0.1 level
Dependent variables ∆Exposure Index ∆Economic structure subindex
Share of foreign direct investment t 0.003 0.002
GDP on logarithm (PPP, $US) t -0.020 0.271
Country dummies Yes Yes Yes Yes Yes Yes
Year dummies Yes Yes Yes Yes Yes Yes
Source: Authors Notes: Standard errors are indicated in parentheses: *** denotes significance at the 0.01 level,
** at the 0.05 level, and * at the 0.1 level.
Robustness checks and heterogeneous effects
Thus far, the research findings confirm two main points First, the impact of commodity shocks on EVI exhibits a lag and peaks within one year following the shock Second, changes in government final consumption are one crucial channel to ensure the stability of an economy While the first finding is evident, the second result may not hold if, in reality, commodity shocks do not alter government tax revenue Thus, to validate this argument, we regress the impact of commodity terms of trade on international trade and transaction taxes If tax revenues remain unaffected for at least one year following changes in international prices, the results may be spurious The estimates are presented in Appendix [3] and align with expectations (Arezki & Brückner, 2012a; 2012b)
Notably, to bolster the second finding, we conduct regressions with interaction terms between commodity terms of trade and indices reflecting government effectiveness (GE) and control of corruption (CC) The logic behind this is that if these results hold, a country with better government effectiveness would mitigate the negative impacts of shocks more effectively, and vice versa Table [7] tests this conjecture and indicates that the coefficients of the interaction term between import shocks and the average value over the period for government effectiveness and control of corruption are positive and statistically significant It should be noted that averaging the indices of government effectiveness ensures the exogeneity of this variable in the model
Table 6 Heterogeneous effects of commodity shocks on vulnerability index: Government effectiveness
Dependent variables ∆Economic Vulnerability Index ∆Trade shock index
Other controls Yes Yes Yes Yes Yes Yes Yes Yes
Country dummies Yes Yes Yes Yes Yes Yes Yes Yes
Year dummies Yes Yes Yes Yes Yes Yes Yes Yes
Source: Authors Notes: Standard errors are indicated in parentheses: *** denotes significance at the 0.01 level,
** at the 0.05 level, and * at the 0.1 level
Classical and neoclassical economists, despite acknowledging the advantages of increased global trade, exercise caution based on international trade patterns Studies have revealed that economic openness can enhance vulnerability to export price fluctuations, leading to potential economic instability Conversely, the impact of import price shocks does not exhibit statistical significance This phenomenon could stem from global or regional trade agreements assumed to be uniform across countries in the study's design.
Table 7 Heterogeneous effects of commodity shocks on vulnerability index: Trade size
∆Economic Vulnerability Index ∆Shock index
Other controls Yes Yes Yes Yes
Country dummies Yes Yes Yes Yes
Year dummies Yes Yes Yes Yes
Source: Authors Notes: Standard errors are indicated in parentheses: *** denotes significance at the 0.01 level,
** at the 0.05 level, and * at the 0.1 level
Lastly, another strategy to validate the study’s robustness is re-estimating the regressions after collapsing the data every 3 or 5 years This technique allows (i) mitigating bias caused by serial correlation of error terms (which often occurs with panel data) and (ii) preventing data manipulation through segmenting the study period The results are presented in Appendix [4] and are consistent with previous findings.
Conclusion & Recommendations on policy implication
The inquiry into the impact of price shocks on the stability of an economy has garnered considerable attention and widespread discussion to date It is hardly surprising to assert that international trade contributes significantly to global economic performance (Freidman, 2005; Krugman, 1995), thereby reducing the distance between nations, yet it also introduces systemic instability, as evidenced by global economic crises such as the 2008 financial crisis and the 1997 Asian financial crisis (Rickards, 2012) This study supplements empirical evidence to elucidate this topic, utilizing global data from 1990 to 2018 The findings highlight several notable points First, commodity windfall, resulting from increased export prices or decreased import prices, reduces economic instability and vice versa This may be explained by (i) government spending on final consumption (Collins, 2017) to modify aggregate demand in the economy and (ii) changes in the real interest rate (Akram, 2009; Akyüz, 2020) The findings are further confirmed by evidence of increased tax revenues during commodity boom periods and, conversely, decreased tax revenue under commodity bust periods (Arezki & Brückner, 2012) Second, more efficient government operation contributes to mitigating the adverse effects of negative shocks in international trade on the economy, while larger scales of international trade may render economies more vulnerable to higher shock impacts (Krugman, 1995) Besides, the examined impacts exhibit a lag of approximately one year and have been corroborated through various estimation techniques
The current empirical study directly supports the school of thought of (neo) Keynesians regarding the necessity of government interference to mitigate shocks from global trade, significantly from the increase in import prices However, criticisms from Austrian economists and neoclassicists may still hold value when considering the long term, where temporary government interventions may disrupt market signals Notably, a corrupt and inefficient government can lead to unpredicted consequences in mitigating global trade shocks The crisis in Venezuela (in 2015) may serve as a real-life observation of high dependence on imported goods without corresponding “cushioning” policies, as government spending sharply decreased due to declining oil prices (Global Agricultural Information Network (GAIN), 2023; Hammond, 2011;
Su et al., 2020) However, striking a reasonable balance in government interventions in the face of macroeconomic shocks without encroaching on its power in other areas remains challenging, especially in transition countries As expressed by Acemoglu and Robinson (2019), shackling Leviathan while still keeping it roaming and growing is akin to walking a “narrow corridor.”
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AFG AGO ARE ARG ARM ATG AZE BDI BEN BFA BGD BHR
BHS BLZ BOL BRA BRB BRN BTN BWA CAF CHL CHN CIV
CMR COD COG COL COM CPV CRI CYP DJI DMA DOM DZA
ECU EGY ERI ETH FJI GAB GEO GHA GIN GMB GNB GRD
GTM GUY HND HTI IDN IND IRN IRQ ISR JAM JOR KAZ
KEN KGZ KHM KIR KNA KOR KWT LAO LBN LBR LBY LCA
LKA LSO MAR MDG MDV MEX MLI MMR MNG MOZ MRT MUS
MWI MYS NAM NER NGA NIC NPL OMN PAK PAN PER PHL
PNG PRY QAT RWA SAU SDN SEN SGP SLB SLE SLV STP
SUR SWZ SYC SYR TCD TGO THA TJK TKM TLS TON TTO
TUN TUR TUV TZA UGA URY VCT VEN VNM VUT WSM YEM
Dependent variables ∆Economic Vulnerability Index
(0.002) (0.002) (0.003) (0.003) Share of foreign direct investment t -0.003 -0.002 -0.003 -0.003
GDP on logarithm (PPP, $US) t -0.335* -0.336* -0.441 -0.711**
Country dummies Yes Yes Yes Yes
Year dummies Yes Yes Yes Yes
Source: Authors Notes: Standard errors are indicated in parentheses: *** denotes significance at the 0.01 level,
** at the 0.05 level, and * at the 0.1 level
Appendix 3 Trade shock on tax revenues
Taxes on international trade and transactions, Total
Taxes on international trade and transactions, Export
Taxes on international trade and transactions, Import
On logarithm Over GDP On logarithm Over GDP On logarithm Over GDP
Country dummies Yes Yes Yes Yes Yes Yes
Year dummies Yes Yes Yes Yes Yes Yes
Source: Authors Notes: the total tax revenue in columns (1), (3), and (5) is estimated using tax over GDP multiplied by GDP (PPP, $US) Tax data is collected from here: https://www.wider.unu.edu/project/grd-government- revenue-dataset Standard errors are shown in parentheses: *** indicates significance at the 0.01 level, ** at the 0.05 level, and * at the 0.1 level.