Managing Commodity Lifecycles, Mining

 6. Impacts of commodity price volatility – exchange rate effectsSource: LME, IMF, Pacific Exchange Rate Service 

Volatile commodity prices can have dramatic impacts on a country’s exchange rate, driving the value of its currency higher when commodity prices are rising and driving it lower when they weaken. Capital inflows and outflows can further magnify this effect. For example, foreign direct investment in resource projects will place additional upwards pressure on a country’s currency.

The graph below shows the relationship between the Zambian kwacha and the price of copper (Zambia’s biggest export).

Note: Values of the kwacha prior to 2015 have been adjusted by the differential rates of inflation in Zambia and the US using annual data for consumer price inflation.

These currency shifts reflect an underlying economic reality. This is that the economic wealth of the country hosting the resource has increased, something which should in time be reflected in higher wages and higher standards of living. However, the speed with which these effects arise can be distorting to the local economy and have undesirable side-effects. As such, they sometimes require management.

The immediate effect of a strengthening currency is to make imported goods suddenly cheaper and thus to encourage importing. This may be a problem when the imported goods are investment goods but is more problematic (and less sustainable) if the surge in buying is focused on consumer goods such as luxury items.

There are also structural challenges posed by currency strength resulting from windfall commodity gains. An increase in a country’s currency increases the foreign currency costs (commonly US dollar costs) of all companies producing internationally traded goods, some of which will not have the benefit of product price increases and which will accordingly see their international competiveness reduced and their margins squeezed.

This is commonly called the Dutch Disease, after the rapid escalation in the currency of the Netherlands which took place in the wake of the discovery of the Groningen gas fields in 1959.

Subject to the scale of exchange rate increases and the likely consequential damage to the overall economy, it can make sense for governments to seek to neutralise the effects of rapid currency appreciation by directing part of the revenues from the mining sector into overseas investments. These capital outflows will put immediate downwards pressure on the local currency. At the same time the accumulation of investments offshore will provide the government with a stock of assets which it can use to support its economy and its public spending when commodity prices are weaker. Such schemes are generally referred to as stabilisation funds.

Several mining countries, including Canada, Chile, Ghana and Papua New Guinea have adopted stabilisation funds. Often such funds take the form of Sovereign Wealth Funds (SWFs). Strong discipline is required to operate such funds effectively and the performance of the funds has been mixed. However, the principle behind them is a sound one and they are an explicit acknowledgement of the special nature of mineral resources and of their associated economics. As discussed in the previous section, there is logic in using a large part of the rent arising from the exploitation of mineral resource production to build up a stock of investments for future generations. The question of what is an appropriate balance in these investments between domestic and overseas investments will vary from country to country.