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Po Ry roh WORKING PAPERS

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Debt Intenmtlonal and Finance

Department trntemational Economics TheWorld Bank Januery 1992 WPS835

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CommodityStabilization Funds
PatricioArrau and Stijn Claessens

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The optimal rule for depositsin and withdrawalsfrom a commoditystabilizationfund: keep the fundsmall - less than one month'sexports. For the windfallgain oil exportersreceivedas a resultof thePersianGulfcrisis-about fourmonthsofaverage exports- the optionaldepletionperiod is aboutfour years. In the long run, the exporter's fund shouldbe small, significantly less than one monthof oil exports.
ThePolicyRese rchWoixngPapens disseminate findings workinprogresand encourage the of theexchangeof ideasamong Bankstaff andall othem intered in development issues.Tlhe papersdistibuted bytheResearch Advisory Staff,carrythenamesof the authots, re*lecatolytheirview,andshouldbeoed ndcitedaccordingly.The ndinp,inteapations, andconclusiomsatetheauthorsown.They shouldnot be atibuted to theWorldBank,its Boardof Dimsors. its management, any of its membercounties. or

Pdlky R.l.arch

Finance and Debt International WPS 835

This paper - a product of the Debt and Intemational Finance Division, Intemational Economics Department - is part of a larger effort in the Department to contribute to a Bankwide work program on issues related to developing country management of external risk, including currency and exchange rate risk management, currency reserve management, and commodity price risk n,anagement. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact room S8-040, extension 31047 (36 pages). January 1992. Sheilah King-WNatson, Commodity stabilization funds are hard-currency savings to protect against a fall in income from commodity exports in the presence of borrowing constraints. Arrau and Claessens develop the optimal rules for deposits in and withdrawals from such a fund by using a benchmark model of precautionary savings with liquidity constraints. They show that the optimal stabilization fund is small. For the Chilean Copper Stabilization Fund, they show that the actual accumulation of foreign assets has been much larger than the benchmark model requires. Over long periods, the copper fund should contain less than one month's exports. They also use the model to find the optimal depletion of the windfall gain oil exporters received as a result of the Persian Gulf crisisto amnounting about four months of average exports. They find that such a windfall gain should be depleted in about four years. In the long run, an oil exporter should keep a small fund, significantly less than one month of oil exportc But higher-than-predicted funds can be justified if there are externalities associated with the fund, frictions in the economy, or the borrowing constraint is relaxed.

The Policy Research Working Paper Series disseminates the fmdings of work under way in theBanrk An objectiveof the series is to get these findings out quickly, even if presentations arc less than fully polished. The fimdings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy. Produced by the Policy Research Dissemination Center

TABLE

OF CONTENTS

1. 2.

INTRODUCTION INCOME FROM EXPORTS

.. ........................................... AND OIL

.

2
4

OF COPPER

. ..
.

. ...

.... .. .

2.1 Copper 2.2 Exports 3. 4. DEATONS

and oil Prices.*

Revenues

.. .......

......

.... SAVING
.....

...

**** * ................................... ....

6
7 13 13

PRECAUTIONARY
..

MODELNODE.. ..
. ....

o..........
.. . . ........ ........ ...

. .

APPLICATIONS... 4.1 4.2 Chile's The

..

copper

stabilixation gain..
..

rund.
..

1990-91

oil windfall .. .. ....

19 . .o 20

S.
n6.

....... EXTENSIONS.

.. . ................... *........

........................... coNCLUsIONS*-*-*--

22 -.*.................... vv
. ....

Reference-n.......
Appendix Appendix I-b e . . A .. .......... B . . .. . . . . . . .. . l0 . .

24 26 28

.............

............................. . .. . . .

..

. .

29 33

Figures ..........

..........................

'We would like to thankRon Duncan, VikramNehru, and Larry Summersfor their commentsand Heinz Rudo!ph for able research assistance.

1.

INTRODUCTION. Many developingcountrieshavelarge exposuresto commodityprice risk becauseof concentrated

export structures. Two methods are availableto reduce these large exposures and/or smooth income fluctuations resulting from commodity price movements: 1) self-insure; and 2) transfer risk to international (capital) markets. The first can be achieved in a variety of ways including: (a) diversificationof the export structure and, (b) accumulationof foreign assets. The second can be achievedthrough a combinationof borrowingand lending in internationalcapital markets, and through commodityprice-linkedhedging instruments. In principle, the second method is usuallyprefe-red: a developingcountrydoes not have a comparativeadvantagein bearingprice risk, while the international (capital)markets at large are better able to do so. However, developingcountries' access to the internationalcapital markets has proven to be far from full. Borrowingfrom internationalmarkets has often proven to be procyclical rather than (the desired) countercyclical. Contingent trrowing facilities (such as the IMF's Compensatory and ContingencyFinancingFacility(CCFF) and the EC's STABEX) have the disadvantage they are often that only available ex-post. Lack of creditworthiness,in general, tends to restrict the access of developing countriesto internationalcapitalmarkets. Accessto comn iodity-linked hedginginstrumentsis, for similar reasons, limited. In addition, for many of the commoditiesfor which developing countries have significantexposure, the markets for long-termhedginginstrumentsare still very limited, e.g., only for metals and energyproducts is there a fairly completespectrumof hedging instrumentsavailable;longterm markets for tropicalcommoditiesare non-existent.' The limited accessto internationalborrowingsand the incompleteness the commodity-linked of

'In addition, many developingcountrieshold a large share of world production of some of these commoditiesand the amountsto be hedgedare often very large comparedto the size of existinghedging markets (for instance, Mexico's yearly oil exports represent many times the daily turnover on the exchangefor oil futures).

3 hedging markets imply that to some extent developingcountries will have to rely on methodsof selfinsurance. Of these methods,exportdiversificationwill often take longerto achieveand may not be the most efficient since it may run counter to the country's comparative advantage. A self-insurance mechanismthat may be a relatively efficient alternativeis the accumulationof foreign assets by the country to act as a commoditystabilizationfund (CSF). A fund like this was establishedin Chile in 1985. During periods of high commodityprices--and high exports earnings-the country would prices. The problem accumulateforeign assets which it woulddraw down in periods of low commodity would thus be very similar to that of a liquidity-onstrained individualwho also has a demand for precautionarysavings. The purpose of this paper is to estimatethe processesfor incomefrom exportsof copperand oil, Deaton's (1991) precautionarysaving and to derive the optimal rules for a CSF using as a benchmarkl model. The problem of designinga CSF is find the optimalrules for deposits and withdrawalsgiven a of particular state of nature. The rules will thereftre dependon the stochasticcharacteristics the income process. Few papers exist on this topic. Hausman and Powell (1991), who assume a random walk process for prices, justify the creation of a fund on adjustmentcosts in the productionprocess of the commodity. Basch and Engel (1991) combine the predictions of a large-scalecopper model with the policy functionsderived by Deaton A) when incomeis assumel stationary. Their workdiffers from

ours in that we derive the policy functionsin accordancewith the incomeprocess estimated. The setup of this paper is as follows. In section two, we determinethe stochasticprocess for incomefrom copperand oil exports. In sectionthree, we presentthe theoreticalmodel(basedon Deaton, 1991) and determine the optimal saving rule given the estimated income process. Our anaiysis complementsDeaton's analysisas we study in-deptha special case-an AR(1) incomegrowth processwhich is discussedonly brieflyby Deaton. In sectionfour, we applythe resultsto the situationof ChileFund-and derive the optimaldrawdownrules for the windfallgain recently and its Copper Stabilization

4 receivedby oil expoiters. In sectionfive, we presentsome possil"e extensions. The last sectioncontains our conci-' ions. 2. 2.1 INCOME FROM EXPORTS OF COPPER AND OIL Copperand oil prices The stochasticprocess of income from commodityexports dependson the stochasticprocesses of commodityprices and volumesexported. From the country's point of view, volumesare, however, subject to considerablyless uncertaintythan commodityprices and, at least in the short run, are more a choice variable. We therefore first model the process of copper and oil prices and then infer the process for income by incorporatingthe volumecomponent. We then verify that we have appropriately modeledthe income process. We start with stationaritytests on the prices of copper and oil. Table 1 summarizesthe result of the tests. Tests are performed on prices in logarithmic-levelsand !ogarithmicfirst differences, in nominal as well as real terms. To obtain a real price of copper, the monthly dollar copper price (London)for the period 1960-90is deflatedby the US CPI index. For oil prices, we use two nominal prices: the West-Texas Intermediate(WTI) price and the actual price of Mexicanoil exports. The former is deflatedby the US CPI indexand the latter by the price indexof importedprivate consumption
2 goods. Table 1 makesclear that the (log) level of real copper and oil prices are likely better modelled

as I(l), i.e., non-stationaryprocesscs, and that the logaritmic difference is stationary. Only when 12 lags are int oduced in the augmentedDickey-Fullertest is there evidencethat the copperprice couiuibe stationary and revert to some mean. On the contrary, for the WTI price series, the ADF(12)test even questionsstationarityin logarithmicfirst differences,but the test is probablyof too low a power as the series is short (83 observations). From Table 1, and giventhe time horizonwe are interestedin and the

2 We also used the price indexes for total Mexicanimportsand for importedgovernmentconsumption goodsto deflatethe Mexicooil price and found virtually identicalresults.

difficulties of incorporatingautocorrelationof high order in the model, we conclude that the level of prices s best modeledas non-stationaryin levels and stationary in first differences. hypothesisis a logical Next we modelthe logarithmicfirst differenceof prices. The randomwialk starting point here. However, Williams and Wright (1991), Deaton and Laroque (1991) and Trivedi (1991) find that typically real commodityprice series do not behave like a randomwalk and that there in is more linear and nonlineardependence the first differenceof prices thanis consistentwiththe random walk hypothesis. Part of this behaviorcan be explainedby the competitivestoragemodel (Williamsand Wright, 1991, and Deaton and Laroque, 1991)which indicatesthat price jumps due to "stock-outs"lead to skewed price distributionsand serial dependence. Trivedi (1991) conjecturesthat more generalized storage modelimply (non-linear)AR processesfor commodityprices. Given versions of the competitive price thereforeas an first order autoregressive the applicationwe have in mind, we modelthe commodity
3 (AR(1))process. Consequently,we estimate:

(AP,

-,,)

-,P(AP.-1

-po)

(1

where:
Pt p
Apt

the log of the (real or nominal)commodityprice, = an autoregressiveparameterless than 1,

=
= Pt - Pt-I,

PIP

et

= unconditionalmean drift of prices. = normal, independent,and identicallydistributed (i.i.d) error with a zero mean and a varianceof a2.

Table 2 summarizesthe estimationof (1) for the copper and oil price, both in nominal and real terms. The table shows that there is a small (inflaticnary)drift in the nominal prices and no drift in the real prices. Except for the drift term, deflatinghas virtuallyno effect on the other parameterestimates(both the autoregressiveterm as wellas the estimatedvarianceof the error are unaffected). This indicatesthat

(e.g., a no-profitscondition in the 3 Using an AR process is consistentwith rational expectations futures markets)because of thleasymmetryintroducedby stockouts.Furthermore, using an AR process biases our results towards findingprecautionarysavings(see footnote2).

6 all real price volatility is due to commodityprice volatilityas the deflatorsare very smooth. 2.2 ExportsRevenues explainmost of the unexpectedmovementsof incomefrom exports, AlthoughpiIce ;movements a full descriptionof the incomeprocessrequiresus to modelthe processfor the volumeexportedas well. The volume of exports depend on production as well as on the inventory decisions. In principle, inventoriesare saving in an asset with return that dependson the price next period (net of any storage cost and depreciation). However, the joint portfolio-savingdecision of production, inventories and financial assets is beyond the scope of this paper.' We concentratetherefore on the income (foreign

exchange)earned from exports and do not make a distinctionbetweenproductionand exports (abstracting thus from domestic consumption). trend (exported)is to assumea deterministic The simplestway to modelthe volumeof commodity process. Table 3 shows the estimationof such a deterministictrend (using annualdata), and Appendix B provides plots of all the series. For Chile, we find that a trend variable can explain 90% of the variance in the volumeof copper exports (and 97% of the variancein production)(see also Figure B.2).
5 Only a small part of the varianceof volumeexportedremainsunexplained. For Mexicoand Venezuela,

however, modellingthe volumeprocessby a trend only does not seem appropriate. Figures B.4 and B.6 show importantstructural changesin the volume of oil exported. Large discoveriesin Mexico in 1976 led to high volume growth in the followingten years until--in part as a result of fiscal adjustmentsexports stagnatedin the eighties. For Venezuela,exportsin the secondhalf of the seventiesdeclineddue to OPEC quota's, but stabilizedthereafterat that level. Since volume variability may influence (offset) price variability, we verified the two-step ' For a model of commodityprice determinationwith storage see Deaton and Laroque (1991) and Williamsand Wright (1991). See Choe (1991)for an analysisof the precautionarydemand for physical stocks in the presenceof consumptionor productionshocks.
5

The low Durbin-Watsonsuggeststhat the copper exports could be non-stationary.

7 derivationof the incomeprocess by directly estimatingan AR(1)process for real (dollar) incomeusing monthlydata.' The parameter estimates(reportedin Table 4) were quite lifferent from those impliedby the two-stepderivation:the estimatefor p in caseof the real incomeof copperexports wasnegativewhile it was positive for the copper price equation; and Mexico's real income itom oil exports resemblesa random walk while for the real oil price an AR(1)was appropriate. The reason for these differencesis the month-to-month behavior of the volume of exports which exhibits strong negativeautocorrelation. We suspectthat this is largely the resultof seasonalityand other (physical)customsrelatedto the shipping of the commodities. We have little reason to believe that next month's volume of exports cannot be predicted accurately by the countries. We considerthe volume of exports accordinglynot a source of risk and we use the two-step derivation for the income process. Future work should, ho;vever, investigatewhy the month-to-month variability is much higher than that impliedby the yearly data. For Chile, an AR(1)for prices and a trend for volumesprovidesthus a good explanationfor the stochasticprocess for income from exports. The incomeprocess has the same distributionas the price in (1), but with the additio,al drift term "'jq" in Table 3 added to the (zero) drift of the real price (J,~ in 1 Table 2). For both oil exporters(where we only have a reasonableprocess for price fluctuationsdue to structural breaks in volumes during the sampleperiod) we simply assume a deterministictrend for the future volume of exports. 3, DEATON'S PRECAUTIONARY SAVING MODEL The benchmarkprecautionarysaving model used here is based on Deaton (1991). He derives the implicationsfor the optimalsaving rule under stationaryas well as non-stationaryincomeprocesses. In light of the empirical evidencepresented in the previous section, we present an abbreviatedversion of his model under a non-stationaryAR(1) income process (the interestedreader is referred to Deaton

'Stationaritytest were also performed (not reported), which indicatedthat income is best modelled as 1(1).

8 for a full derivation). The precautionarysavingsmodelis based on the notionthat the individualor countryfacessome constraintson its borrowingswhich prevent it from smoothingadverseincomefluctuations. This is very realistic for many developing countries, including Chile, Mexico and Venezuela. Even though these countrieshave beenreceivingsomeprivate voluntarycapital inflowslately--inparticularMexicanprivate and public companieshave gained renewedaccessto international(bond)markets--mostof this renewed of access has been project or companyspecific. There is no indicationthat the govern-ments these (and capital .narketsto smoothadverseincomeshocks. many other) countriesare able to use the international We assume that the governmenthas an objectivefunctionwhich is a functionof a sequenceof consumption,provisionof publicgoods, a socialprogram, etc.--to be financed expenditures-government with the income from commodityexports. We assumethat all other expenditures,asset accumulation, and policy decisions by the government can be separated from the saving and expendituredecisions related to commodityincome.' We further assume that the governmentis risk averse. Becauseof the volatile income stream from commodityexports and the borrowing constraint, the governmenthas an incentiveto set up a fund (CSF) to smooth income fluctuationsoptimally. Formally, the government maximizes the expected value of a function of the control variable, saving, subject to budget and borrowingconstraints.
V, =
(1+,,6s,IBLFU(G,) I

s.t.

F,, 1c(1+r)(F,+Z,-G,)
F,kO

(2)

where:
7 Alternatively, could have assumedthat all unexpecteddeviations total incomecan be attri',uted of we

to commodityprice (income)fluctuationsor that all other expenditures,asset accumulation,and policy decisions of the government can be separated. As a third option, we could have assumed that the government acts benevolently on behalf of the country's risk-adverse citizens who are borrowing constrainedthemselves.

9 E = the expectationoperator, u(.) = the objectivefunotion,satisfyingthe usual (concavity)conditions, G, = sequenceof govermment expenditures, X, = income from exports, F, = assets in commodityfund, 6 = rate of time preference, r = internationalinterest rate. Becausethe income process X, is non-stationary,the model is best normalizedby dividing all variables by the incomein that period. The iower case letters indicatenormalizedvariables, i.e., x,+, = g,= Gt/X,; and f, = F,/X,. By specifyingthe utility functionto display constantrelative risk aversion
1 (CRRA) (i.e., u(g) = gl /(l-a), where a is the relative risk aversionparameter),the normalizedmodel

can be expressed as the solutionto the followingtwo equations:

`= max{ (1+f*) (ler) I

x,+,

3)

(3)

5(1r)
5.1~~~t.

( 1f,-g,)

(4)

Equation3 is the (modified)Euler equation. Becauseof the borrowingconstraint,the expenditure ratio in the current period has to be less than 1 plus the fund ratio, that is g S (1 + f). If the

borrowingconstraintis not binding,then g, is such thatthe marginalutilitytoday is equalto the expected marginalutility tomorrow appropriatelydiscounted. Becausemarginalutility is convex, precautionary saving will result and consumptionwill be less than under perfect certainty. Equation(4) is the law of motion for the fund ratio. For a given process ';: x,+, we can find a policy function p(f, x) which maps the two state 1 variables f, and x, into the control variable g, = p(f,, xe). From the previous section, we know that (conditionalon informationin period t) x,+, is lognormallydistr6uted with conditionaldistribution N(u(l-p)+plog(x.), o2) FollowingDeaton(1991), we approximatethe normal distributionfor log(x,+) 1

10

with a ten-value, discrete Markov process.' Therefore, we numericallycomputeten policy functions, g = p(f, i), i = 1,... 10, which map the fund ratio onto the expenditureratio-given that state "i" was realized. AppendixA describesthe btpnsto obtain the ten policy functions. Replacingthe policy functionsin (3) and using (4), the (ten)equilibriumconditionsof th' model can be written as follows

al,,

) axf(1f.-', X--

(1+3)

g(5)

where wrjis the probability of state j occurring in the next period giver that state i occurred in this to x,+ period. In this formulaLion, takesone of ten discrete values. We checkedthis approximation the income process by simulatingthe discrete process for Chile's copper exports and verified that the simulatedseries provides estimatesfor the income process very similar to those of Table 2 and 3 (see furtier Appendix A). to Figure 1 showsthe ten policyfunctionscorresponding the aboveincomeprocessand parameter values et, 8, and r of 2, 0.08, and 0.04 respectively. We start with ci = 2 mainl; because estimations of the degree of relative risk aversionfor the US economyhave found the value 2 to be in the lower range. The policy functionsare upward sloped,mainlybecausea higherfundratio implieshigherinterest earnings on the foreign assets which allows for a higher expenditureratio. The policy functions corresponding to good states lie above those correspondingto bad states; because of the positive autocorrelationin the growth of income, a good state indicatesa higher likelihoodof more good statesto and thus a higher (permanent)income-leadingto a higher ratio of consumption assetsat hand. A bad

of ' Note that using a (discrete)ML .ov process allowsfor easy approximation other, non-symmetric distributionsas long as they are of first autoregressiveorder.

11
9 state, however, results in increasedsaving in anticipationof likely lower future income growth.

We can see from Figure I that this combinationof parameters leads to little saving. Savings would only take place if either the worst state or next to worst state is realized and when there is no moneyin the fund. As soonas the fund reaches5% of incomeall policyfunctionsindicatethat spending exceeds income (an expenditureratio greater than 1). In this structure, the fund will be depletedover
10 time. We have also used a very high monthlyinterestrate and social rate of time preference (A% and

8% respectively)for reasons that will be spelledout below. It is clear from Figure 1 that higher saving will only result if most of the ten policy functions have an expenditureratio below one for low fund ratios. We tried several parameter combinationsto obtain this. Figure 2 shows the sensitivityof policy functions (for the worst state only) for different vaiues of the CRRA, interest rate and time preferenceparameters. The figure showscases of a between 0.5 and 0.8 only, which is very low comparedwith estimatesobtained for the US. For high values of
a and reasonable interest rates, we found greater difficulty in obtaining convergenceof the numerical

algorithm. To understand this, we need to resort to the sufficient condition for the existence of a stationary, stochasticrational expectationequilibriumin this model. As shown by Deaton (1991), this conditionfor the i.i.d growth case is: E[(1 + r)/(l + 6) x+, 1] < 1. For simplicity,we will discussthe unconditionalversion of our AR(1)growth case. Using the approximationx = log(l +x), taking logs, and using the unconditionallognormaldistributionfor xt+ (AppendixA), we can express the condition 1 as:

9This countercyclicalbehavior of saving is emphasizedby Deaton (1991) who states that this is a counterfactualimplicationof his model. However, recent (Latin American) experienceshows often a consumptionboom and a drop in saving in the beginningof recovery (Mexico in 1989and 1990is the most recent exan.ple).
10 Strictly speakingwe must also considerthe differencebetweenthe rate of incomegrowth and the rate of interest as we do below. The statementabove is still accurate,however.

12
a 1 '(r-6)
+

CT,__ < ' 2( I ~p2 )

(6)

The left hand side of equation(6) is the expectedslope of the expenditurefunctionof the unconstrained problem while the right hand side expressionis the expectedgrowth in income. If the former is lower governmentwouldlike to obtaindebt and the borrowingconstraintwould thanthe latter, an unconstrained be binding. Note that the expenditureslope (left hand side of equation (6)) comprisestwo terms. The first term is the life cycle componentof savings and is the slope of expenditure in the absence of uncertainty. The term is positivefor r >
a

and vice-versa. The importanceof this term dependson the

inverse of the CRRAparameter a (the intertemporalelasticityof substitutionin this framework). The second component of the expectedslope of expenditureis motivatedby precautionarymotives. The higher the volatilityof income, the higher the precautionarymotive impliedby the convexnature of the marginalutilityof consumption, the higherthe expectedslope of expenditure accountof this term. and on Becausethe volatilityof income is so large for commodityexporters-as shown above, a value of a as high as 2 generates a large desire for precautionarysavings and requires a large differential between the interest rate and time preference parameter to satisfy condition (6). But, the required calibrationof the modelwas not alwayspossible. For reasonableinterestrate and time preferencevalues, no convergencyof the policy functionsresultedfor a = 2. For instance, in the case of (a, 6, r) = (2, time preferencerate which was7 percentagepointshigherthan 0.12/12, 0.05/12), even the (annualized) the interest rate was not enoughto compensatefor the desire to raise precautionarysavings. To furtherevaluatethe largeuncertaintywe observe, considerthe followingcomparison. Deaton (1991) presents a simulationfor US quarterly data with an (AR(1))growth process for income and a CRRAparameterequalto 2. For his simulation,incomegrowth fluctuatedbetweena maximumof 2.5% per annum and a minimumof -0.5%. In the caseof copper, (monthly)incomegrowthprocessfluctuates between-12.0% and 12.7%, a much larger range. The difficultiesfaced in calibratingthe model with

13 CRRA parameters higher than 1 are therefore predominantlydue to the high volatility encounteredin commodityprices."' Another compellingreason to use a low a is evidencefrom Euler estimationsfor these countries
2 which suggests a lower value than the one typically estimated for the US." The availableempirical

evidence,combinedwith the fact that lower valut.zof a still implylarge precautionarysavings,reinforce

3 the notion that a low value of a is appropriatein this context." The net effect of the high volatility for

commodityincomeand a somewhatlower a can still generatea higher demandfor precautionarysavings than Deaton's simulationswith US data imply. In the next section we apply the model to the Chilean copper stabilizationfund and the recent windfall gain for oil exporters. 4. 4.1 APPLICATIONS Chile's copper stabilization fund Chile's exports are highly concentratedin copper. Even though, as a result of govermnent policies, Chile has reduced its dependenceon copper significantlyover the past decade, still more than

utilityfunctionwe use where high RRAparameters " Of course, we are limitedby the time-separable the imply low intertemporalelasticity. Obviously,there would be great benefit from disentangling two utilityframeworkof Epsteinand Zin (1989, 1991),Farmer (1991)and parametersas in the non-expected Weil (1991). Althoughthe empiricalevidenceis limited in this regard, estimationsfor Chile and Mexico-in the context of a monetary model-suggest a point estimate for a of 0.63 for Chile and 0.35 for Mexico (Arrau, 1990). These estimatesare not very precise-for instance, a value of 1 for Chile could not be ruled out.
12

'3In fact, becausevolatility is so much higher in Latin Americathan in the US, the low estimatefor such a high volatility, axcould very well be the result of a misspecifiedmodelthat cannot accommodate and therefore results in biased estimatesfor a. Applicationsof the Euler approach to developing countries with annualdata (Ostry and Reinhart, 1991) result in valuesof a of the order of 2. Because annual data is less volatile than quarterly or monthlydata, it seems plausible that the estimateof this parameter might be driven by the volatilityof the series employed in the estimations. Applicationsto Mexico of the more flexibleframework of the Epstein-Zinmodel (Arrau and van Wijnbergen, 1991) for show that the RRAparameter is around 1, in concordancewith estimations the US (Epsteinand Zin, 1991; Giovaninniand Weil, 1990).

14 50% of exports comes from this source. Furthermore, since most colpperis produced by state-owned mines, it is a very importantsource of reverue for the Treasury. Volatilecopperprices can also 'fect the competivenessof the rest of the Chileaneconomythrough movementsin the real exchangerate. Chilean authoritieshave long been aware of the importanceof managingthis risk. In 1981they establishedrules governingthe treatmentof excesscopper revenues. In 1985they establisheda Copper StabilizationFund (CSF) as part of a StructuralAdjustmentLoan agreementwith the World Bank. The first deposit into the CSF was subsequentlymade in 1987. The rules of the CSF stipulatethat deposits (or withdrawals)will be proportionalto the excess of the copper price over trigger prices which are establishedas two bands (narrow and wide) around a reference price. The reference price is set in real terms (adjusted for dollar inflation) and cannot exceed a six year moving average of the spot price. Within the narrow band there would be no deposits or withdrawals;outside the wide band all excess copper revenues wouldbe deposited(if price is above)or withdrawn(if price is below); and in between the two bands 50% of the excessshould be deposited(if above)or withdrawn(if below). Furthermore, withdrawalswere only to be used for "extraordinaryamortizationsof public debt".'4 Table 6 presents to figures corresponding two differentmeasuresfor the fund. The first measureconsidersas withdrawals only current expenditures,i.e., the subsidyto grape exportersin 1988-89to cover the damagescaused by the US ban on grape exports from Chile in the wake of al!egationsabout cyanide poisoning. The second measurealso includesas withdrawalscapital expenditures,i.e., repurchasesof externaldebt by the Central Bank in the secondarymarket. The CSF has clearlyprovideda mechanismfor avoidingunwantedpoliticallygeneratedpressures latter qualificationhas led to some confusionaboutthe exact nature of the fund-a Treasury fund or part of foreign reserves-and severaldefinitionsare used to measuredepositsand withdrawalsin transactionsbetweenthe Treasuryand the Central Bank the fund, includingsome coveringthe accounting (e.g., prepaymentof debt by the Treasury to the Central Bank), which consequentlyshows a very low balance for the fund at the end of 1990. It should also be notedthat there is some lack of clarityas to of the final purposeof the CSF; officialdocumentsindicateits purpose to be "stabilization fiscal income from copper receipts" as well as "stabilizationof the real exchangerate".
14 The

15 to spend funds accumulatedduring periods of unusuallyhigh copperprices. From an economicpoint of view, however, the mechanicsappear (in addition to being confusing)to lack a solid foundation. For process generatingcopper instance, the reference price is set withouttaking into accountthe unde.rlying prices formation. Furthermore, the rules for accumulationand withdrawaldo not considerthe level of the fund as the model above does." of Two different parameterizations the benchmarkmodel are used to evaluatethe performance of the CSF. In order to make the conclusionsmore robust, we use the two parameterizationsmost favorable to saving in Figure 2. As mentionedabove, this implies a value for u = 0.5, and a = 0.8 (Cases I and 2 res,-.ctively). In both cases, the annualizedinterestrate is 5%. However, in Case 1, the time preference is assumedto be equal to the monthlyinterestrate minus 0.05%, which leads to a small desire for life cycle saving. In Case 2, the rate of interest and socialtime preference are assumedto be equal. It is importantto emphasizethat the borrowing constraint is never binding in Case 2.16 This impliesthat this case can only be valid if one believesthat a borrowingconstraintdoes not constitutean essentialpart of a model for Chile, and its results are biased towardshigher savings. We first discuss the results of Case 1. Figure 3 depicts the ten policy functions for this configuration. The very flat policy functionsfor modestly-high fund ratios indicatelittle change in the expenditureratio as incomeincreases. This is mostlydue to the low interest rate assumed, whichresults in little interest income and thus a low expenditureratio even for a higher fund ratio. Close to a zero fund ratio, however, the slopes of the policy functionsincrease sharply as a result of the nonlinearities introducedby the borrowing constraint. Moreover, the five worst states of nature generate saving for all fund ratios, while the five best states of nature generate dissavingfor almost all fund ratios. Since

"Independently,Btasch Engel (1991)make this pointtoo. and '"All ten policy functionsfor Case 2 intersectthe vertical axis below 1 and thereforethe borrowing constraintis not bindingfor any.

16 every state of nature has equal probabilityof occurrence, we can see from Figure 3 that for high fund ratios the unconditional(average) policy function implies dissaving. The fund ratio can therefore not increase forever but will be mean-reverting. A typicalsimulationfor 200 periods using these policyfunctionsis shown in Fig Ire 4. We plot the growth factor "x" (plus one for clarityof presentation),the expenditureratio, and the fund ratio. As can be seen, the fund ratio is stationary, as for high values of the fund, dissaving occurs (unconditionally). For this particular simulation,the averagv fund ratio is about 0.30 (30% of one month's income). We repeatedthe simulationlike the one underlyingFigure 4 1000times. Table 5 presents some data based on these 1000replications. The results show that the average fund ratio is higher, 0.66, with a standarddeviationof 1.344. The averagefund ratio is misleading,becausethe fund is boundedbelow by zero. We therefore also present the medianfund ratio, 0.383. The importantresult to note is that both the mean and median fund ratiosare very small, implyingless than one monthof export incomeheld in foreign assets. So even with a parameter combinationthat leads to a relatively high desire for precautionarysavings and litde life cycle saving, the optimalfund is relatively very small. However, a small fund may still result in large smoothingof income. Table 5 shows the mean and standarddeviationof the drift of the expenditureratio, which can be comparedto the parametersof the incomeprocess (Table 4). Table 5 showsthat the standarddeviationof expendituresis 40% less than the standarddeviationof income, indicatinga considerable degree of smoothingfor such a small fund. Table 5 also presentsstatisticson the marginalpropensityto spend (consume)(MPC)out of incomefrom exports (excludingthus, interest income), which is obtainedfrom linear regressionsin levels as well as in log differencesfor every Monte Carlo replication. The regressionin levels suggestsa MPC equal to one, which is not optimalin our framework. One wouldexpect improvementin results by using a linear specificationin levels, since the cointegratednature of the regression would provide more consistent

17 statistic suggests,the borrowing constraintintroduces estimates. However, as the low Durbin-Watson an asymmetry in the errors (consumptionis not symmetric)that casts doubt that this is a cointegrated err.rs) provides equation. The MPC derived from the regressionin log differences (with well-behaved the correct answer. The correct marginalpropensityto spend out of incrementalincome is thus about 0.56, not one. Finally, we applythe modelto Chile usingthe actualcopperprice realizedsince 1987. We first classifythe actualprices betweenSeptember 1987and December 1990to one of the ten statesof nature (details in AppendixA). Usingthe appropriatepolicy function,we then computethe optimalfund ratio. This is done for both cases describedabove. For Case 1, Figure 5 shows the evolutionof actual income growth x (plus one for clarity of presentation),and the optimal fund and expenditureratios for every month. Based on this analysis,the fund shouldoptimallyhave amountedto about 20% of one month's worth of export income at the end of 1990. Case 2 is depicted in Figure 6. As noted above, this parameter combinationimpliesthat the borrowingconstraint is irrelevantbecauseof the absenceof the desire to borrow for life cycle motives and because of the high level of desire to save for precautionary motives. Consequently,in Case 2 the fund is never depletedcompletelyduring the period 1987-1990. Even in this high-savings,no-borrowingdesire case, the fund should have reached a level equivalentto only 2.2 times monthlyexports at the end of 1990. Table 6 comparesthe actual deposits, acccrdingto the two definitionsof the fund spelledout above, and the two simulationcases. As we can see, the stock of the fund was between$2.4 and $1.9 billion by 1990, depending on the assumptions made about capitalizationof interest (zero and 2% quarterly respectively). These levels correspondto about six to seven times the average monthlyincome in the last quarter of 1990 (and about 25% of annualtotal exports). The third and fourth columnsare computed by applying the derived optimal monthly saving ratio to the actualmonthly exports from October 1987to December 1990, and then cumulatingthe monthly saving for each quarter. By using

18 actualmonthlyexports, we preventthe high month-to-month variability in the volumeof exports (which we kept as certain in the theoreticalmodel) from influencingthe differences betweenthe optimalfund and the actual fund. For Case 1, the model suggeststhat the fund should optimallyhave been between $60 and $70 milliondollars at the end of 1990(20% to 22% of monthlyincome). However,the actualfund was six to seven times monthlyexports, or more than thirty times as large as predictedby the benchmarkmodel under Case 1.*7 Even in Case 2 (the non-borrowingconstrainedbenchmark),the actual fund was only three times as large as desired (between $580 and $640 million). Clearly, from the point of desired consumptionsmoothing, there has been a substantialoveraccumulationof foreign assets in the CSF through the end of 1990.13 The optimal level at the end of 1990does not necessarilyrepresent the optimal long run fund level. Equation (4) canbe rewritten, by substitutingthe expectedgrowth rate for income(1 +,) for x,+, and setting f,+ equal to f,, as one of two conditionsthat define the stochastic, stationarysteady state. 1
u -= 1( -r)
(7)

The secondconditionfor the steady state is the (unconditional) policy function,p(f) = , 0.1 *p(f, i), the state weightedaverage of the equation(5) policy functions. Figure 7 plots these two functionsfor the parametersof Case 1. The intersectionof the two functionsrepresentsthe steady state value of f. In Case 1, the steady state ratio of f is about 0.30-close to the median value in our earlier Monte Carlo

Baschand Engel(1991)who-assuming stationaryprices-find that the fund should have been between $835 and $1649 millionat the end of 1990 (in constant 1989dollars). '3 There may be one caveat to this observation. Foreign exchange reserves are not held for precautionaryreasonsonly: for example,transactiondemand(to cover imports)also gives rise to demand for rew-ves. If, during the perixd that the Chilean authorities accumulateda too large CSF, other demandwas reduced, then the overaccumulation would have been less. However, then the CSF needs to be defineddifferentlv.

17Thisdiffers from

19 simulations(Table 5). Note that the stationarystochasticsteady state for f is stable as the slope of p(f) is higher thanthe slope of (7). Thereforefor f valueshigherthan 0.30, the unconditionalpolicyfunction impliesan expenditureratio higherthan the one compatiblewith a stationaryf and the fund wouldbe run down (in an expectedvaluesense). For valuesof f lower than the equilibriumvalue, the oppositeis true and the fund increases(in an expectedvalue sense). For Case 2 (not shown), the state steady ratio of the fund is much larger, about 16, confirming the higher desire for savings under this set of parameters. 4.2 The 1990-91oil windfall gain The increase in oil prices from August 1990to January 1991due to the Gulf Crisis represented a windfall gain for oil exporters. The income gain for a typical oil exporter can be approximatedas being equal to four months of normal exports (for example, in the case of Mexico, prices were on average 80% higher than in the previousyear during roughlyfive months). Both Mexicoand Venezuela did not spend the windfall, but investedit (Mexicoused part of it to retire public debt and Venezuela establishedan oil stabilizationfund(alongthe linesof the ChileanCSF)). The questionarises, how much of the windfallshouldbe investedand how it shouldbe spent over time. As we showed in the previous section,the optimalfund size for copperamountsto only about0.2 monthsof imports. The oil windfall is much more than that: four months. This does not mean, however, that it would be optimalto deplete the fund quickly. Questionsregardingthe optimalspe"d at which to depletea windfallgain of this magnitudecan be determinedusing the benchmarkmodel, given the estimatesfor the Mexicooil income process. In accordancewith the results of section2, the real price is held constant. Since, as was shown earlier, it is not clear what is the volume drift for Mexico (and Venezuela), we solve the ten policy functions assumingp = 0.003, or 0.3% export volumeincrease per month. We use values for other parameters as follows: a = 0.5, 6 = 0.08/12, r = 0.05/12 and the estimatesp = 0.48 and oa = 0.005723 from

20 Table 2. Note that becausea2 and p are both larger than those for copper,the unconditionalvarianceof incomefrom oil exports is evenlarger than from copperexports. To partiallyoffset the resultinghigher desireto save for precautionary motivesand to obtainconvergence the algorithm,we use an annualized of time preference of 8%. The exerciseuses the unconditionalaverage of the ten policy functions-insteadof using Monte Carlo simulations,so the results should be interpretedin an expectedvalue sense. Figure 8 shows the optimal, unconditionalexpenditureratio, g = p(f), and the relation (7). Starting from a fund ratio of four, the optimalpolicy is to run the fund down by consuming(in an expectedsense) along the function g=p(f), using equation (4), until the fund ratio reaches its long-run level of about 0.10. The exercise leads to the followingresults. In the first year, the fund ratio is reduced from 4 to 2.13 months of exports. In the next two years the fund ratio is fulther reduced.o about0.33 at the end of the third year and in year four to about 0.13. Therefore, the optimalpolicy is to run the windfallgain down slc vly: a windfallgain worth four months of exports should be run down over a period of about 48 months. 5. EXTENSIONS A straightforwardextensionof the model is to considerthe interactionwhich may exist between commodity price movementsand interestrate movements. If interestrates are stochastic,then the optimal saving rule will dependon the varianceof interest rate movementsand the covariancebetween interest rates and prices. The effect of a stochasticr is best demonstrated lookingat the sufficient condition by for the existenceof an equilibrium. Equation(8) showsthe condition(which replacesequation(6)) when the growth process for income is independent,identicallydistributed:

a'I (r -8

r ) +

<

(8)

where r standsnow for the expectedinterest rate, a2, for the varianceof r, a2' for the varianceof log(x), and o2,.,, the covariancebetween log(x)and r. The existenceconditioncan, in a heuristic way, show for

21 the effect of introducingstochasticinterestrates. If a',.. is positive, then introducinga stochasticinterest rate is similar to increasing the slope of the income path, since an income shock is to some extent exacerbated by an interest earnings shock (and vice-versa for a negative covariance). Interest rate volatilityper se (the term a', on the left hand side) acts as an increase in the interest rate whui. is likely to generate more saving. However, empirically, this modificationof the model is not likely to be significant. For the period 1975-90,for instance,using the US T-bill rate and the logarithmicdifference in copperprices, o2,is about 1.08xl
5 4 and o',.. is about 1.7xlO .

We have shown in the previous section that a well designed and well managed commodity stabilizationfundwill lead to a reasonableamountof smoothingof short-term incomefluctuations. How doesthis smoothingcompareto the results of using other risk managementmeasures?Short-termmarketbased, commodityrisk managementinstruments--futures options-are one of the possibilitieshere. and Margin requirementsassure that credit risk is not an issue, and, in principle, make these instruments availableto (entitiesin) all countriesat low costs. Through simulations,Claessensand Varangis (1991) found that oil futures could rerr:;e up to 85% of price risk for periods one to two months ahead. For longerperiods, these instrumentsstill reduceduncertaintyby up to 81%. Similar results were foundfor coffee (approximately 70% risk reduction)and canbe found for hedgingmany other commoditieswith market-basedinstruments. As a short-termhedgingtool, market-basedinstrumentscould thus perform equally well or better than a CSF in removingshort-periodvolatility at lower costs. Especiallyin the presenceof spikes and fatter tails in the commodityprice distributionit may be even more efficient to hedge using market-basedinstruments (especiallydesigned to remove the effects of spikes, such as options)insteadof holdinglow-yielding assets in reserves. It is surprisingthat to date so few developing countrieshave used these instruments. Becausethesehedginginstrumentshaveshort maturities,they willprovide--evenwith rollingover

22
9 of the hedges--limitedhedgingvalue over longer periods."

Longer-datedinstrumentswould thus be

desirable. The market for longer-termcommodity hedginginstrumentsis thin, however, and, so far, less available (or only on unattractive terms) to many developing countries due to institutional, creditworthiness,and other constraints.' It would appear, therefore, that the best strategy to follow

for a commodity-dependent country would be to remove as much short-periodcommodityprice risk as possiblethroughshort-datedinstrumentsas well as--tothe extent possible--uselonger-termhedgingtools. The CSF mechanismcan be used for smoothingany remaininglonger-periodrisk. 6. CONCLUSIONS This paper concludes that given actual commodityprice processes observed, and assuming reasonable values for other parameters, a risk-averse, credit-constrained country would only wish to maintaina relativelysmall CSF, amountingpossibly to only a fraction of one month's export income. UsingDeaton's (1991) precautionarysaving model with liquidityconstraints, we found that the Chilean Copper StabilizationFund should have held only about 20% of monthly incomefrom copperexports at the end of 1990-far less than the actual level of six to seven times monthlyincome held at that time. Even if Chile is assumednot to be a credit-constrained, fund should only have been abouttwo times the the monthlyexports at the end of 1990. The opportunitycost of maintainingsuch large liquid foreign reserves to smooth adverseincome shocksis too high, even grantinga high degree of risk aversion. How can we explain CSFs as large as the Chilean case? One, seeminglyrational explanation, could be that the fund provides positive externalities,such as an increase in overall confidence,which justifies keepinga large amountof low-yieldingassets even whenone is credit-constrained. Part of this "The problemwith rolling-overcoveragebasedon short-termmaturinginstrumentsis that this usually implies a large exposure in these instruments.This can imply large margin calls and/or large option premiums, makingthe instrumentsless attractivefor foreign-exchange constrainedcountries. 'Instruments such as commodity swaps involve credit risks, compete with other credits to the borrower, and may thus not be availableto the countryon attractiveterms.

23 improvedconfidencecouldcome from a stabilization the real exchange rate, which may benefitother of sectorsof the economywhen there are costs of adjustment. Baschand Engel (1991) explore this notion by introducingfrictions in adjustinggovernmentprograms. Other possible benefits of holding a CSF includereduction in (a) the public pressuresto quicklyspend windfallincomegains, (b) spendingwhich either takeson a life of its own and cannotbe reversed,and (c) spendingwhich is inefficient. These are, however, more politically-oriented explanationsand have little appeal from an economicpoint of view. The benchmark model was also used to compute the optimal depletion rule for a typical oil exporterthat receiveda windfallgain of aboutfour times its monthlyexport revenuesduring five months of high oil prices as occurredduring the Gulf crisis. The paper showthat the typicaloil exporter should take about four years to depletethis large a windfallgain. Our paper complementsDeaton (1991) by providing an in-depth study of the AR(1) growth process for income. We show that, even for risk aversion Parametersless than 1, the much higher volatilityencounteredin the incomeprocessesof developingcountriescomparedto developedcountries (becauseof dependingon volatile commodityprices) implieshigh levels of precautionarysavings. Finally, future work which deals with the use of self-insuranceschemes such as commodity stabilization funds shouldtake into accountthe existenceof commodity-linked contingentinstrumentsand present an integratedanalysis, giventhe possible substitutability complementarity and between the two. Especiallythe benefitsof market-based instruments designedto removethe effectsof spikes in commodity prices, such as options, needs to be explored. Further analysisof the volume and the price components of incomerisk is anotherfruitful researchavenue.

24
Rdfirences

Arrau, Patricio (1990), "Intertemporal Substitutionin a MonetaryFramework:Evidencefrom Chile and Mexico", PRE WorkingPaper # 549,The World Bank, December. Arrau, Patricio and Sweder van Wijnbergen(1991), "IntertemporalSubstitution, Risk Aversion and Private Savingsin Mexico", PRE WorkingPaper # 682, The World Bank, May. Basch, Migueland EduardoEngel(1991), "Shockstransitoriosy mecanismosde estabilizacion",mimeo, CIEPLAN,October. Choe, Boum-Jong(1991), "The PrecautionaryDemand for CommodityStocks", mimeo, IECIT, The World Bank Claessens,Stijn and Panos Varangis (1991), "HedgingCrude Oil Imports In DevelopingCountries", PRE WorkingPaper # 755,The World Bank, August. Deaton, Angus (1990), "Savingin DevelopingCountries:Theoryand Review", Supplement,The World Bank EconomicReview(Proceedingsof the World Bank Annual Conference-onDelo2me Enomics 1829)vol. 4, 61-96. Deaton, Angus (1991), "Saving and Liquidityconstraints",Econometrica,vol. 59, no. 5, September, 1221-1248. Deaton,Angusand GuyLaroque (1991), "On the Behaviourof CommodityPrices", Reviewof Economic Studies, forthcoming.[NBERworkingpaper # 34391 Epstein, L. G. and S. E. Zin (1989), "Substitution,Risk Aversion, and th,e Temporal Behavior of and Consumption AssetReturns:A TheoreticalFramework",Econometrica,vol. 57, no. 4, July, 937-969. Epstein, L. G. and S. E. Zin (1991), "Substitution,Risk Aversion, and the Temporal Behavior of Consumption Asset Returns:An Empirical Analysis", ournalof Political Economy,vol.99, and no. 2, April, 263-286. Farmer, R. (1990), "R.I.N.C.E. Preferences", Ouarterly Journal of Economics, vol CV, Issue 1, February, 43-60. Giovannini,A. and P. Weil (1989), "Risk Aversionand IntertemporalSubstitutionin the Capital Asset Pricing Model", NBER WorkingPaper # 2824, January. Hausmann, Ricardo and Andrew Powell (1990), "El fondo de estabilizacion macroeconomica: lineamientosgenerales,", mimeo, IESA, Caracas, November Mackinnon,James (1990), "Critical Values for CointegrationTests", working paper, University of California,San Diego, January.

25 Ostry, Jonathan and Carmen Reinhart (1991) "The Harberger-Laursen-Metzler Hypothesis: Evidence from DevelopingCountries",InternationalMonetaryFund, Washington,mimeo, August Tauchen, G. (1986), "Finite State Markov Chain Approximation to Univariate and Vector Autoregressions",EconomicLetters, 22, 237-55 Trivedi, P. (1991), "Time Series Behaviorof Some CommodityPrices", mimeo, IECDIT, The World Bank Weil, P. (1990), "NonexpectedUtility in Macroeconomics", OuarterlyJournal of Economics, vol CV, Issue 1, February, 2942. Williams, Jeffrey and Brian Wright (1991), Storageand CommodityMarkets, Cambridge University Press.

26 AppendixA: of Computation policy functions

The first step is to compute the 10-pointdiscrete Markov approximationto the continuous, autoregressiveprocess for log(x,+,). If log(x,+,)is distributedconditionalon the informationin period distributedas N(ju,u2/(l - p2)). t as N(j(1 - p) + p log(xJ, a;), then 1,g(x,+) is unconditionally 1 To approximatethe unconditionaldistribution, we follow Deaton (1991) and Tauchen (1986). First divide the real line R in 10 segmentsof equal area under the unconditionaldensity so that every segmentof the distributionhas a one tenthprobabilityof occurrence. Let at,... ,ak be the nine valuesthat divide the 10 segments (from left to right) and let a3 = -mo and a10 = x. Every segment of the O. distributionof log(x) is now representedby its within-intervalmean z1 ,...,z1 (For the case of copper income distributionzt = -0.120 and z,0 = 0.127). Because the process is positivelyautocorrelated,given a value z; in the previous period, it will be more likely that this period realizationwill be close to zi. This can be representedby the Markov transition matrix with typical element7rj, which stands for the probabilityof state j, given that state i occurred last period. Unlike Deaton (1991), and more along the lines of Tauchen (1986), we approximatethis transition matrix by computing
fjfj

= Pqa,>log(x

1+1

) 2 a, 1 I log(x,)

=z,]

We use thus the conditionaldistributionof log(x,+,),and the transitionprobabilitieswhich can easily be computednumerically. We verify the accuracy of the discrete approximationby simulation.We simulatethe income for process using the parameterization Chile: (u, 02,p) = (0.0032, 0.004436, 0.32). The drift i&= Fp + Aqis obtained from the first regressionsin Table 2 and 3 respectively(the estimateof p, in Table 2 is taken as zero) and the other two parameterscome from the first regression in Table 2. We simulate process for incomefrom these 1000replicationsof 370 observationseach and estimatethe autoregressive 1000replications. Table Al comparesthe values from the actualregressionswith the average estimates from the Monte Carlo replications. We can see that our approximationto the true process is very accurate as true and simulatedestimatesare very close.

27 Table Al: Simulationof incomeprocess:

AX = y(1 -p) + p X., + e,

e,is N(0, a2) True Parameters 'U(l-p) p a2
2 R

Mean Simulation 0.00214 0.306 0.004277

Standarddev. Simulation 0.00332 0.0599 0.00027

0.00218 0.320 0.004436 ^

0.0956
1.99

0.0301
0.0326

D.W.

+ &). Columns 2 and Note True parameterscome from the first equation in Tables 2 and 3 (a = 3 come from OLS estimationsof 370 Monte Carlo simulationseach, replicated 1000 times. For each estimatedparameterand statisticwe presentthe mean and the standarddeviationof the 1000replications. underlyingFigures5 and 6 and Table 6, we first classifythe actualrealization For the simulations of the logarithmicdifferenceof real copper pricesbetweenSeptember1987and December 1990 (adding the drift u = 0.0032) so one of the ten intervalsof the unconditionaldistribution. The ten policy functionsare computedby iterating equation(5) in the text, which as discussed by Deaton (1991), are contractionmappingsfor some sets of parameters.

28

Appendix& CommodityProductionand Exports for Chile, Mexicoand Venezuela(volumes)

Cn le: Copper ProductIon Chi le COoper Exports

140 .40~~~~~~~~~~~~~~~~~~~~~~~~~~2

110ico:

011

Production

Mexico.

Oi

ExC>os22

110

06

*0

*0
..

600_
,i .

(index,1977=100)
11 0 /0

(million pounds)
0''0

ltexico:

Oil Production
16

MexICO. Ofl

Exports

10

lie~~~~~i
.06

~~~~~~~~~~~~~~~~~~~~~~~~~~~0

. 00 M0

4"'i

n4M11

(KToil equivalent) (KCT equivalent)

(KT equivalent) (KT oil equivalent)

Venezuela:Production Oil

Venezuela:

Oil

Export~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Source anldNotes: See Table 3.

29 Table 1: Integrationtests for real commodityprices. Are the series stationary? DF C Real Copper Price log level NO log. diff. YES Real Oil Price West-TexasInterm. log level NO log. diff. YES Real Oil Price for Mexico log level NO log. diff. YES CT NO YES NO YES NO YES ADF(4) C NO YES NO YES NO YES CT NO YES NO YES NO YES ADF(12) C NO YES NO NO NO YES CT YES(*) YES NO NO NO YES #obs 372 371 83 82 132 131

Note:Dickey-Fuller and Augmented (DF) Dickey-Fuller (ADF) testsat 5%criticalvalue.Applied the logof the to levelof pricesand logarithmic difference prices. Thenominal of copper(1960.01-1990.12) theWest-Texas and intermediate price(1984.01-1990.12) deflated the US CPI. An indexof imported oil are by privateconsumption goods usedto deflatetheoil pricefor Mexico is (1980.01-1990.12). means only theconstant included 'C' that is in thetest; 'CT' means constant wellas trendareincluded thetest. Thecriticalvalues thetestscomefrom as in for Mackinnon (1990).(*)Rejectat 10%criticalvalue. Sources: Banco Mexico, lIndicadores de Economicos'; IMF, International Financial Statistics base. data Table 2: Estimationof commodityprice processes A log(p,) = 1p(1 - p) + p A log(p,.1) + e, e, is N(0, o2)
R2
A,

(1 - ,3)

p 0.320 (6.47) 0.317 (6.41) 0.356 (3.34) 0.364 (3.42) 0.483 (6.11) 0.493 (6.26)

(02)

DW 1.88 1.88 1.82 1.82 1.78 1.79

Real copper price Nominalcopper price Real oil price WTI Nominaloil price WTI Real oil price Mexico Nominaloil price Mexico

-0.00057 (-0.17) 0.00222 (0.64) -0.00367 (-0.35) -0.00160 (-. 15) -0.00323 (-0.48) -0.00188 (4.28)

0.10 (0.004436) 0.10 (0.004417) 0.12 (0.008841) 0.13 (0.008980) 0.23 (0.005723) 0.23 (0.005727)

Not: t-statistics parentheses. in Source:IMF-Intenational Financial Statistics set;Banco Mexico,*Indicadores data de Economicos". WTIstands for theWestTexasIntermediate price. Deflator the US CPIindexexceptfor Mexico is wherethedeflatoris an index the unitvalueof imported of privateconsumption goods.

30 TIable3: Volume Index Chile Copper produced 1960-90 Copper exported 1960-90 Mexico Fuel produced 1961-89 Fuel exported 1965-88 Venezuela Fuel produced 1961-89 Fuel exported 1965-88 Note: t-statistics parentheses. in
Sources: Mexico and Venezuela: International Econoraics Department, The World Bank, Energy data set. Production and export index is in terms of kilo tons (KT) oil equivalent. Chile: Banco Central de Chile y 'Indicadoreseconomicos sociales1960-88', and 'Monthly Bouletin'. Productionindexfor copperis 100for 1977. Volumeof copper exports is derived by dividingthe nominaldollar amountof copperexports (in millions)by the LondonMetal Exchangecopper price (cents/pound).

Estimationof deterministictrend for volume of commodity Log(Q) = intercept + pq t + et Intercept 3.844 (191) 2.111 (43.5) 9.268 (99.1) 9.196 (86.9) 12.251 (252) 12.259 (216)
Jlq

R2 0.97 0.91 0.93 0.91 0.78 0.71

DW 1.31 1.01 0.15 0.13 0.33 0.31

0.00318 (34.9) 0.00371 (16.9) 0.00835 (18.4) 0.00897 (14.5) -0.00280 (-9.9) -0.00287 (-7.3)

31 Table 4 Direct Estimationof IncomeProcess

A log(X.)= t( - p) + p A logQ4.,) +
f,

e,

is N(O,a)
2 R

1, (I- P) Real copper exports Nominalcopper exports Real oil exports Mexico Nominaloil exports Mexico -0.00016 (0.01) 0.01043 (0.46) 0.00195 (0.12) 0.00509 (0.32)

p -0.598 (8.42) -0.597 (8.40) -0.108 (1.23) -0.102 (1.15)

(o2)

DW 2.06 2.05 1.98 1.98

0.36 (0.0655) 0.36 (0.0655) 0.01 (0.0320) 0.01 (0.0321)

Nte: t-statisticsin parentheses. Source: Dollar copperexports values come from IMF, IntemationalFinancialStatistics. Oil exports values come from Bancvde Mexico, lIndicadores Economicos".Deflator is the US CPI index for copper and an index of the unit value of importedprivate consumptiongoods for Mexico. Table 5:

Simulationof Full Model for Chile, Case 1 Mean

Simulation

Standarddev.
Simulation 1.344

Fund ratio (f)

0.657 (0.383a)

A log (G) s. d. A log (G) M.P.C in level

- Durbin-Watson M.P.C in log diff. - Durbin-Watson

0.0015 0.0402 1.000

1.46 0.559 2.01

0.0028 0.00173 0.00672

0.189 0.0146 0.0540

Note: Mean and standard deviationof 1000 replicationsof the simulatedmodel with 200 observationsin each replication. M.P.C. is the marginalpropensityto consume(spend)out of income from exports. It is obtainedby a linear OLS regression between the simulatedexpendituresequenceand income sequence. In the first case the regressionis in levels and in the second in growthinnovations (log differences). In both cases we reportbelow the M.P.C the Durbin-Watson statisticfrom the OLS regression. (a) median(midpoint)

32 Table 6: Comparisonof actualand optimum quarterlydeposits in Copper StabilizationFund for Chile (millionsof US dollars) Deposits Net of Expenditure Withdrawals 0 (grape crisis) 1987.IV 1988.1 1988.11 1988.111 1988.IV 1989.1 1989.11 1989.III 1989.IV 1990.1 1990.1I 1990.111 1990.1V Fund 1 Fund 2a
Fund 1/Expb.

Deposits Net of Expenditure + Capitald Withdrawals 26.36 125.34 146.95 140.77 -87.15 467.51 112.17 219.93 -53.16 263.34 79.65 229.32 239.76 1910.9 2119.3 6.0 6.6

Model Case 1 -2.37 21.45 -1.71 2.63 -28.65 18.11 34.31 -24.91 33.92 -10.46 3.32 -18.77 36.07 62.9 69.1 0.20 0.22

Model Case 2 21.76 51.24 33.34 37.01 13.90 58.24 73.06 26.72 82.41 25.50 49.81 27.08 76.56 576.60 643.40 1.8 2.0

26.36 125.43 146.95 140.77 82.85 467.51 112.17 219.93 40.40 263.34 79.65 229.32 239.76 2174.4 2419.7 6.7 7.6

(months) Fund 2/Expb. (months)

without interest capitalizations. 2 usesa Fund of Nots : Fund1 is thestock assetsat theendof theperiod interest 2%. of quaterly nominal million. copper exports thelastquarter 1990wereUS$320 in of b: Theaverage monthly exporters purchase to debt out of crisisbyallowing c: Funds wereusedto smooth theeffects thegrape inatrumentsthesecondary in market thenreseU and them theCentral ata price to Bank closetopar. Bank of repurchased external of theCentral (in theamount $252.3million).Other debt d:Thegoverment Bank Source:Fundfigures: "accounting' transactions between Treasury theCentral arenotconsidered. the and Ministry Finance; of Copperexports:CentralBank,'MonthlyBouletin-

33

GAUSS

Figure

1:

Policy

Functions,

p(f),

for a given

state

0.04,

0.08,

00 D 0a 4

bes

statett

C:

0
'3 0. 0. 0. 03 0. 0. 0. 07 0. 0. 10

o> 0.0 (D 0.1 0.2

ofPliyFncina(ostsaeeny ~ .Sensitivity ~ ~ ~ ~
0.3 0.4 0.5 0.6

~
0.7

~ ~
0.8

rs
0.9 1.0

fund ratio
GAUSS

(f)

Sensitivity

of Policy

Figure 2: Functions

(worst

state

only)

(0

x
-~cc

~~~~~r

=0.05/126 =r-0.000,

0)

=0.05/12.

O.O/1. 0.5 6

0)0

oo-

.0.05

.1.

.r.

a - 0 .

0.0

0.1

0.2

3 4

0 5

0 6 (f)

0.7

0.8

0.9

1.0

fund ratio

34

GAUSS

Figure
O . . r .

3:

Policy

functions

base

simuiation

case

~~~~~~~~~~~best state
.r 05/1 2.
= r

0.0005.

0.5,

04

03 CL

worst state

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

Fund ratio (f)

GAUSS

Figure

4:

Typical

simulation

for

Chile

Ni

income

growth foctor

+ 1 (1 + x)

expenditure

ratio (g)

O
0

fund ratio

(f)

20

40

eo

80

100

120

140

160

180

200

time

35

GAUSS

Actual Simulation

Figure 5: for Chile: 1987-1990,

Case 1

04

+ income growth factor ( 1 + x)

expenditure ratio (g)

00

12

16

20

24

28

32

36

40

months from September 1987 through December 1990

GAUSS

Actual Simulation

Figure 6: for Chile: 1987-1990,

Case 2

(N

1 + income growth factor (1 + x)

expenditure ratio (9g)

und rotio (f)

12

16

20

24

28

32

36

40

months from September 1987 through December 1990

36

GAUSS

Figure

7:

Long-Run

Fund

Level for

Chile,

Case

O4

g =POt

0 o
o .-r/ Fr

00

09
co/0)

o^ a 0.18

,I.

0.003x,

0.05/12

0.0041 -

0.22

0.26

0.30 fund ratio (f)

0.34

0.38

0.42

GAUSS

Depletion
CN

Rule

Figure 8: of the oil Windfall

Gain for Mexico

p(f

x-

04

4.-~~~~~~2163.

O)

or
+

g a 0.003 - 0.05/12, 6 =0.08/12 C~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~I

a _

o .5. s

- 0 005723.,o p

0.48

l 0.0

0.4

0. 8

.6

20

2.4 (f)

28

;5.2

3.

fund ratio

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AJ=

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