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Macroeconomic Instability For Emerging Markets Thanks To Commodity Bust

Macroeconomic Instability For Emerging Markets Thanks To Commodity Bust

The bust in commodity prices is sending ripples through the world of emerging markets.

Countries depending on resource extraction and exports of commodities have run into a brick wall this year the prices collapsed for all sorts of materials – oil, gas, coal, gold, copper, and more. The bust presents macroeconomic risks to these countries, and the risks are greater for economies that are less diversified and more dependent on commodities.

Already, we have seen the sharp loss in value for currencies in emerging markets. China devalued its currency over the summer, sending a wave of panic through emerging markets. The currencies of commodity exporters (Russia, Brazil, Mexico, Nigeria, and Iraq, just to name a few) were already under pressure before China’s devaluation, but China’s decision threw the weaknesses of emerging markets into sharp relief. Related: Has Oil Finally Bottomed?

Commodities tend to go through booms and busts. The seeds of the latest “supercycle” for commodities were planted around a decade ago. Capitalizing off of the scorching growth in China, capital-intensive resource extraction projects were planned around the world. Between 2005 and 2014, a staggering $745 billion worth of investment flowed into new oil, gas, and mining projects. The sum peaked in 2008 and 2009, when petroleum and mining projects accounted for 10 to 12 percent of total foreign direct investment around the world.

Of course, an oil project, or a new coal mine takes several years to build and to bring online. That explains the massive volume of new capacity for all types of commodities that came online in the last two years or so. In other words, the run up in commodity prices between 2005 and 2010 sparked a wave of investment, but all that new capacity came online in 2013-2014, popping the bubble in commodity prices.

Now, we are seeing the opposite of what took place in the last decade. New projects are being cancelled, and investment is drying up. At least $200 billion worth of investment in energy projects alone have so far been cancelled, with potentially much more still to come. That could plant the seeds for a new shortage in the years ahead, in which commodity prices will boom again. Related: A Key Indicator Low Oil Prices Are Lifting Demand

But that boom is a ways off. For now, investment is slowing. And that creates risks for commodity-exporting countries, especially for those that are wholly dependent on natural resource extraction.

The International Monetary Fund published a new report that describes various methods for commodity exporters to buffer against the worst effects of a commodity bust. For example, countries that build up “fiscal buffers” (revenues saved from good times to use during bad) can “cushion” the impact on the economy. A perhaps more important method is economic diversification. Governments need to use the revenues from, say, oil exports and use them to invest in infrastructure, health care, and education.

The IMF says that in order to better manage commodity cycles, countries should 1) have long-term fiscal targets, 2) intensify efforts to diversify the economy, 3) make public spending more efficient, and 4) strengthen institutions. Related: With a Collapse in Commodity Prices, What Happens Next?

This is hardly breaking news, as the least diversified, more resource-dependent, and more corrupt countries have long suffered from slow growth and poor economic outcomes for their citizens. But the latest bust highlights how difficult it can be for commodity-based economies to adhere to these pretty straightforward macroeconomic ideas. For example, it’s difficult to invest in quality public education – which necessarily requires consistent and long-term funding – when government revenues surge and fall with such extreme volatility.

Now that commodity prices have crashed, it will become apparent which countries have better prepared their economies for lean times, and which have put all their eggs in the commodity basket. Venezuela may be the poster child for how to squander your resource abundance, while other countries such as Mexico, Brazil, or Australia, for example, will fare better despite the painful collapse in prices.

By Nick Cunningham of Oilprice.com

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