Commodity Price Volatility and Inclusive Growth in Low-Income Countries

Chapter 4. Commodity Price Volatility: Impact and Policy Challenges for Low-Income Countries

Rabah Arezki, Catherine Pattillo, Marc Quintyn, and Min Zhu
Published Date:
October 2012
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Hugh Bredenkamp and Julia Bersch 


The roller-coaster experience of recent years has highlighted the fact that commodity price fluctuations are an integral part of the global economy.1 During 2007 and the first half of 2008, global food prices rose by more than 50 percent and fuel prices doubled. Then, when the financial crisis hit in late 2008, these prices plummeted by 30 and 50 percent, respectively, before rising again sharply in late 2010 and early 2011 (Figure 4.1).

Figure 4.1Commodity Prices Have Displayed Substantial Fluctuations in Recent Years

Sources: IMF, World Economic Outlook; and IMF staff estimates.

Commodity price volatility matters particularly for low-income countries.2 These countries are hit by large terms of trade shocks almost six times more often than advanced economies, reflecting in part LICs’ dependence on primary commodities.3 And the consequences of commodity price shocks are typically far more severe for LICs. The two recent shock episodes highlighted the powerful impact of such shocks on external and fiscal balances, inflation, and poverty in LICs.

It has long been recognized that commodity price volatility can create large swings in LICs’ external balances. The impact on an individual country depends on its trade structure—about one-third of LICs depend on commodities for more than half their exports. Of this group, nine countries are net oil exporters, while the majority of LICs are net importers of food, fuel, or both. As a result, commodity price movements create winners and losers, both within and across countries. If food prices increase, for example, food-exporting LICs benefit from higher export receipts, while food importers have to pay higher import bills. At the same time, in the food-exporting countries, farmers are likely to see their incomes increase, while the urban poor are likely to face a significant deterioration in their purchasing power.

In addition to the impact on trade, global commodity price shocks tend to create strong inflationary pressures in most LICs. This is because food prices are highly correlated with other commodity prices, and food accounts for nearly half of the consumption basket in LICs compared to less than 20 percent in Organisation for Economic Co-operation and Development (OECD) member countries. Even if underlying inflation pressures are contained, high “headline” inflation rates can obscure this fact, putting central banks’ credibility at risk and complicating monetary policy (Figure 4.2).

Figure 4.2Given the High Share of Food in the CPI Basket, the Pass-Through of International Food Price Movements into Headline Inflation Is High for Many LICs

Sources: IMF, World Economic Outlook; and IMF staff estimates.

Note: CPI: consumer price index; LIC: low-income country; OECD: Organisation for Economic Co-operation and Development.

As a result of the strong inflationary impact, global commodity price surges tend to squeeze real household income and can push millions of people into poverty. Moreover, they can create food security problems and distributional shifts, such as from urban populations to rural ones.

The potentially severe social consequences of higher food and fuel prices can trigger political pressures that prompt governments to take countervailing fiscal measures. Broad-based and poorly targeted measures, such as generalized subsidies, tax cuts, or public sector wage hikes, can be very costly to the budget and, more importantly, difficult to unwind. The impact on overall fiscal balances depends on the size of new spending on the one hand and the effect on fiscal revenues on the other hand. For resource-rich countries, fiscal revenues are highly volatile, as they tend to move together with commodity prices (IMF, 2011d). While periods of high global prices can boost revenues in these countries, such windfall gains can also lead to additional spending pressures that then may be difficult to unwind when commodity prices fall again.

Not only are LICs far more exposed to global commodity price volatility than most advanced countries, but they also have fewer built-in smoothing mechanisms than other economies. Their tax systems tend to be less progressive, they typically lack well-developed social safety net systems (such as unemployment insurance), domestic credit markets are undeveloped (making it harder for producers and consumers to borrow during hard times), and they have more limited access to global capital markets. Many will try to compensate by holding high levels of international reserves to self-insure against shocks, but this can be a costly strategy.

The remainder of this chapter will analyze LICs’ vulnerabilities to commodity price shocks in the current macroeconomic context, assess the impact of a possible further surge in commodity prices, and discuss policy implications. We conclude by discussing some of the steps that countries can take to increase their resilience to external shocks and volatility.

Assessing Lics’ Vulnerabilities to Commodity Price Shocks

Macroeconomic Context and the Recent Commodity Price Shocks

LICs have been hit by a series of external shocks, starting with the surge in food and fuel prices in 2007 and 2008. As many countries were still coping with the fallout from those price shocks, the global financial crisis intervened, triggering a sharp fall in exports, remittances, and foreign direct investment, thereby reducing GDP growth across most LICs in 2009. The social consequences were severe—World Bank estimates suggested that an additional 64 million people were left in extreme poverty by the end of 2010.

Throughout this period of extreme turbulence, real GDP growth remained positive in per capita terms in most LICs in contrast to many advanced economies and emerging market countries. Thanks to greatly improved policy performance over the previous decade, LICs entered the global recession in 2009 with much stronger macroeconomic buffers against shocks than in the past. Compared with previous downturns, LICs started out with smaller fiscal and current account deficits, lower inflation, stronger international reserve coverage, and—thanks in part to debt relief—lower debt burdens. As a result, most LICs were able to maintain or even increase spending despite lower revenues, allowing fiscal deficits to widen. This countercyclical response helped to keep per capita growth rates positive in most LICs, while also boosting spending on critical investments and social measures to mitigate the impact on the poorest (IMF, 2010). Beginning in early 2010, a strong economic recovery got underway in most LICs, synchronized with the rest of the world and increasingly supported by demand from new middle-income trading partners (Figure 4.3).

Figure 4.3Most LICs Have Grown Strongly, with Only a Modest Uptick in Inflation in 2011

Sources: IMF, World Economic Outlook; and IMF staff estimates.

Note: LICs: low-income countries; RHS: right-hand scale.

In late 2010 and early 2011, LICs’ economies were again confronted with a surge in global commodity prices. The macroeconomic impact of the commodity price surge appears to have been more contained this time around. With some notable exceptions, the increase in inflation has been relatively limited in most LICs and less than expected based on historical pass-through. The modest uptick in inflation reflects, in some cases, good harvests and measures adopted to limit pass-through of international prices. Since LICs were still recovering from the crisis when the current commodity price shock hit, demand pressures were likely limited, further mitigating the inflationary impact. However, inflation has displayed substantial regional variation, partly explained by regional idiosyncrasies, such as weather and differences in consumption baskets. The international price of rice, for example, did not rise as much as prices for other food staples, which may help explain why the inflationary impact in many Asian LICs was contained. By contrast, inflation has hit double-digit rates in a number of drought-afflicted East African countries.

In the most recent upturn, greater synchronization of price increases across various commodities has contributed to mitigate the impact of the price shock on the trade balance in many LICs. Although the current commodity price surge has been comparable in scale to the one seen in 2008, it has been more broad-based across commodities. Oil exporters have clearly benefited from higher export prices, while the current account balance of net oil importers has deteriorated, but by less than in 2008. For some countries, higher export prices for other commodities such as metals and agricultural raw materials have partially offset the negative impact on imports from higher food and/or fuel prices.

The majority of LICs took fiscal measures to mitigate the social impact of the commodity price shock. The cost for the budget is estimated to have been higher than in 2008, in part because several countries have not unwound measures taken during the previous episode of higher commodity prices. Nevertheless, the commodity price shock has had a substantial impact on poverty. The World Bank estimates that in low- and middle-income countries, about 44 million people were pushed into poverty in early 2011, compared to an estimate of 105 million during the 2008 episode (Ivanic, Martin, and Zaman, 2011).

Looking ahead, LICs face a highly uncertain global outlook with elevated downside risks. And they are now less well prepared to cope with another external shock than they were prior to the onset of the crises in 2007, as fiscal and external buffers are still well below their precrisis levels. Although the most pressing and imminent risk stems from another possible global downturn, commodity prices could stay at elevated levels over the medium term and may well spike further once confidence in the global recovery returns. The analysis of the impact of a further surge in commodity prices is discussed in the next section.

Tail Risk Scenario of Another Commodity Price Shock

As the world’s economies have become increasingly interconnected through trade and financial flows, shocks have begun to propagate more quickly and widely across the globe. This has led the IMF to step up its focus on the associated vulnerabilities and downside risks to its member countries. In this context, we have recently launched the first “vulnerability exercise” for LICs based on a set of new analytical tools to “connect the dots” between emerging risks in the global outlook, LIC-specific vulnerabilities, and their potential repercussions for policies.4 We have used this framework to examine, among other risks, the possible implications of a further global shock to commodity prices.

Using market expectations embedded in commodity futures options, we have identified the shocks that could occur if commodity prices rose to levels in the top 7 percent of the expected probability distribution. Specifically, under this scenario, food prices are assumed to increase by 25 percent in 2011 and 31 percent in 2012 relative to our baseline forecast, fuel prices by 21 percent in 2011 and 48 percent in 2012, and metals prices by 21 percent in 2011 and 36 percent in 2012 (Figure 4.4). (These shocks are somewhat larger than those observed in 2007 to 2008 or 2010 to 2011.) The effects of these shocks were then simulated on a country-by-country basis, taking into account past shock episodes and countries’ different trade structures, sectoral employment, and consumption baskets. This permitted a country-specific analysis of the impact on growth, inflation, fiscal balances, public debt, trade balances, reserve coverage, and poverty.

Figure 4.4Under the Higher Global Commodity Price Scenario, Inflation in Low-Income Countries Could Double Relative to the Baseline Projection, Mainly Driven by Higher Food Prices

Sources: IMF, World Economic Outlook; and IMF staff estimates.

Note: Scenario-simulated impact based on an increase in global food and fuel prices (for food by 25 and 31 percent in 2011 and 2012, respectively, and for fuel by 21 and 48 percent, all compared to baseline).

The analysis shows that a further commodity price spike would not cause a major slump in growth, but the social implications would be substantial, owing mainly to higher inflation. Assuming that the pass-through from global to domestic prices follows historical patterns, inflation could double to about 16 percent in 2012 for the median LIC, driven mainly by higher food prices.5

This inflation burst would likely put pressure on governments to pursue mitigating fiscal measures; consequently, fiscal balances could deteriorate by almost 1 percent of GDP, reflecting existing policy measures (such as fuel subsidies) and possible adoption of new measures (such as tax breaks, transfers, or subsidies).6

Using data on household income distribution and consumption baskets, we estimate that an additional 31 million people would be pushed into poverty under this scenario. About half of the increase in poverty would be in sub-Saharan Africa, reflecting the large population that clusters near the poverty line.

The consequences for the external balances would also be substantial. Current account deficits would widen by almost 3 percent of GDP for the median LIC. Although food prices have a larger impact on inflation than fuel prices, the opposite is true for the trade balance. Only commodity exporters, oil exporters in particular, would benefit from higher prices on balance. For noncommodity-export-ing LICs, international reserves would fall, reducing the median import coverage to just over three months of imports (Figure 4.5). Under this scenario, additional external financing needs could reach US$9 billion in 2012 for LICs experiencing a negative terms of trade shock. Though much of the additional financing needs would be accounted for by a small number of large noncommodity exporters, about half of the countries negatively affected by the shock would face additional financing needs amounting to more than 2 percent of GDP in median terms.

Figure 4.5Another Commodity Price Shock Could Severely Erode Fiscal Room for Maneuver and Reduce the Median Reserve Coverage to about Three Months of Imports

Sources: IMF, World Economic Outlook; and IMF staff estimates.

Note: The illustrative fiscal space measure is calculated as the difference between the baseline 2012 primary balance and the constant primary balance that is needed to achieve a target public debt–to–GDP ratio of 40 percent in 2030. Simulation of fiscal space and the reserve coverage ratio after an increase in global food, metals (except gold and uranium), and fuel prices (by 31, 36, and 48 percent, respectively), relative to the 2012 World Economic Outlook baseline.

On balance, some LICs, notably commodity exporters, would have reserve cushions and fiscal room for maneuver that would allow them to absorb, possibly fully, the impact of this shock without jeopardizing macroeconomic sustainability. Many others have partial policy space to preserve spending but may need to take actions to safeguard or eventually rebuild macroeconomic buffers after a shock. About 15 percent of LICs have fiscal and external buffers that are already quite constrained under the baseline scenario.

Policy Responses to Commodity Price Shocks

External volatility and, in particular, commodity price volatility complicate the conduct of fiscal and monetary policy in several ways.

In the face of increases in global commodity prices, the standard “first-best” policy advice is to pass the higher prices on to consumers while supporting the most vulnerable through well-targeted social safety net systems. This approach can prove difficult to implement in practice, however. First, political pressures on governments to provide relief do not come only from the poor. In many LICs, food and fuel prices have significant effects on household budgets even for higher income groups (see Figure 4.6). Second, LICs typically do not have established systems for providing targeted support to vulnerable groups. As a result, governments are often tempted to fall back on broad-based subsidies that are inefficient and financially unsustainable.

Figure 4.6Higher Global Food and Fuel Prices Would Affect Mostly the Poorest, but also Middle-Income, Households

Sources: IMF, World Economic Outlook; and IMF staff estimates.

The challenge, then, especially for countries with limited fiscal space, is to find pragmatic solutions that are cost-effective. A number of countries made successful strides in that direction during the 2007–08 commodity price shocks. Specific measures adopted have included (1) well-targeted commodity price subsidies, such as the ring-fenced import duty exemptions for diesel in Liberia; (2) agricultural input subsidies, in the case of food price shocks, to stimulate domestic production, such as those used in Malawi to increase maize production; (3) ad hoc social support schemes, such as food voucher programs with proxy means testing in Burkina Faso,7 school-based feeding schemes and “job for food” programs in Sierra Leone, and conditional cash transfer programs targeting vulnerable groups in Ghana and Kenya; and (4) import tariff reductions on selected items consumed mainly by the poor, which provide relief while limiting the revenue loss, such as that on kerosene in Senegal.

Commodity price volatility also poses great challenges for monetary policy, particularly in LICs where the frequency of external shocks is high and their direct impact on domestic inflation is large. Commodity price shocks put policymakers in the difficult position of having to choose between accommodating higher domestic inflation, potentially undermining central bank credibility, and tightening policies, which could exacerbate the negative economic impact of the price shock (Figure 4.7).

Figure 4.7There Is a Strong Direct Impact from Global Food Prices on Domestic Inflation, while Second-Round Effects Are Relatively Limited

Sources: IMF, World Economic Outlook; and IMF staff estimates.

Note: Full pass-through is calculated as the sum of estimated coefficients for contemporaneous and lagged change in global prices divided by (1 – coefficient of lagged inflation).

The standard policy advice, which is to accommodate the direct impact of commodity price shocks while counteracting potential second-round inflation pressures, is even less straightforward in LICs than in other countries. This is in part because the first-round effects of higher commodity prices on inflation are usually much greater than in more advanced economies, reflecting the large share of food in the consumption baskets in LICs. The good news is, however, that second-round effects appear to be less of a concern in LICs than in more advanced economies. The evidence suggests that inflation inertia is relatively low in LICs and, hence, that the impact of shocks on inflation may dissipate relatively quickly.8 This may in part reflect the fact that wage indexation and bargaining mechanisms are less prevalent in LICs than in other countries. Hence, while an accommodative monetary policy stance would be associated with high inflation volatility, it is unlikely to lead to persistent inflation problems.

Nevertheless, countries that have limited reserve cushions and/or high inflation prior to an adverse external price shock may not have the luxury to accommodate the price effect fully. Doing so would aggravate the pressures on the balance of payments, potentially threatening international reserves, and could jeopardize the credibility of their anti-inflation stance. Noncommodity exporters with limited reserves or high inflation may also face difficult choices in determining the appropriate exchange rate policy, as depreciation may be needed to safeguard reserves, but would aggravate inflationary pressures. In short, although some LICs may be able to follow the textbook monetary policy advice and accommodate external price shocks, others may need to tighten policies in support of external and price stability when the shock hits.

How to Increase Resilience

Although coping well with shocks ex post is important, there are also steps that countries can take ex ante to reduce their exposure or create space for more robust responses in the face of future volatility.

Most importantly, LICs can build up stronger policy buffers during good times by moderating deficits and debt when growth is strong or terms of trade are in their favor and by gradually building up comfortable foreign exchange reserve cushions. As earlier IMF work has shown, those LICs that had more comfortable macroeconomic buffers prior to the global crisis were able to pursue a more forceful countercyclical response than countries that had weaker buffers, with larger increases in real spending (see Figure 4.8).9

Figure 4.8During the Global Downturn in 2009, Low-Income Countries with Ample Macroeconomic Buffers Were Able to Mount a Stronger Countercyclical Fiscal Response

Sources: IMF, World Economic Outlook; and IMF staff estimates.

Rebuilding macroeconomic buffers has an opportunity cost, of course—resources set aside cannot be used to meet the many immediate development needs that countries face. There are a number of ways to mitigate this difficult trade-off, however, by creating additional policy space over the medium to long term.

First, LICs can make their budgets more structurally robust by strengthening domestic revenues and improving their systems for managing public spending and debt. This could be done, for example, by strengthening customs and tax administrations and introducing simple, broad-based value-added taxes. Furthermore, by carefully selecting and prioritizing public investment projects, countries’ objectives in key areas such as core infrastructure, health, and education can be achieved at lower budgetary costs (IMF, 2011b).

Second, LICs can put in place more flexible and robust social safety net systems, rather than scrambling to take ad hoc measures after a shock hits, so that transfers can be channeled promptly and in a more cost-effective manner to vulnerable groups adversely affected by shocks (Gupta and others, 2007; Coady and others, 2010).

Third, over the longer term, LICs can pursue reforms to encourage domestic savings and deepen their financial sectors, which could make it easier for both the public and private sectors to finance themselves through periods of temporary turbulence.

Fourth, LICs should also explore policies that would encourage greater diversification in an economy’s production and exports so that price volatility, particularly in products, becomes less disruptive.

Finally, countries need not rely solely on “self-protection” or “self-insurance”—they can seek support from others, including international financial institutions (IFIs) like the IMF and the World Bank, but also from financial markets. IFIs have done a lot in recent years to provide more predictable and quick-disbursing financial assistance to countries hit by shocks. At the IMF, we continue to look for further reforms in this direction. A recent study by the World Bank and IMF has also explored the potential for greater use by LICs of market-hedging products, disaster insurance, and debt instruments with shock-contingent repayment terms (IMF, 2011c). These kinds of tools have been used very little by LICs so far, and there is scope for the international community to help facilitate their deployment on a wider scale. Such efforts would complement the coordinated international initiatives already underway to improve the transparency and functioning of global commodity markets, which seek to foster greater price stability for basic products that are critical to the livelihoods of people throughout the developing world.


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Hugh Bredenkamp and Julia Bersch are affiliated with the International Monetary Fund.


This chapter draws extensively on the IMF report Managing Global Growth Risks and Commodity Price Shocks—Vulnerabilities and Policy Challenges for Low-Income Countries (IMF, 2011d).


The set of low-income countries in this chapter includes all countries eligible for concessional financing from the IMF under the Poverty Reduction and Growth Trust, except for Somalia, which has been excluded due to lack of data.


For a detailed analysis of macroeconomic volatility in LICs, see IMF (2011a).


The analytical framework developed to assess vulnerabilities and emerging risks from changes in the external environment is described in IMF (2011a). It focuses on LICs’ exposure to sharp growth slowdowns in the face of external shocks. The analysis presented here is based on IMF (2011d), which reports on the results of the first vulnerability exercise for LICs, which was conducted using this new framework.


The analysis assumes that the pass-through from global to domestic prices follows historical patterns and that, as in the past, only mild countervailing monetary policy actions are taken.


We assume that for each percentage-point rise in oil and food prices, countries adopt similar fiscal countermeasures to those seen during the 2007–08 episode.


“Proxy means testing” refers to the practice of using household characteristics to identify the poor or vulnerable, rather than trying to measure income directly.


See IMF (2011d) and references therein.


For more on this topic, see IMF (2010, 2011d).

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