The Effect of Commodity Price Shock on the Ethiopian Economy
Naser Yenus Nuru1 Hayelom Yrgaw Gereziher2
Abstract
The main purpose of this study is to examine the effect of commodity price shock on the
Ethiopian economy for the sample period between 1991Q1 up to 2016Q1. The effect of the
shock is analyzed using Jorda’s (2005) local projection method. The shock is, however,
identified by applying short-run contemporaneous restrictions in a vector autoregressive model
based on cholesky decomposition. The results signify that output is positively affected by the
shock to the commodity price. In addition, domestic consumer price responds positively and
significantly to world commodity price shock after the first quarter. The commodity price shock
has also a positive effect, on impact, on money supply. Foreign exchange reserve increases
significantly from the fourth quarter onwards and real effective exchange rate appreciates on
impact, though insignificantly, in response to the increase in commodity price.
Keywords: Commodity price shock, economic growth, local projection method, Ethiopia
1 Assistant Professor of Economics, Adigrat University, Ethiopia. Email: [email protected] Lecturer of Economics, Adigrat University, Ethiopia. Email: [email protected].
1
1. Introduction
The inclusion into the world economy has helped countries in promoting specialization,
achieving higher productivity, attaining economies of scale and technological progress that
enhances economic growth. To the contrary, it has brought trade imbalance, ineffective domestic
policy and financial market volatility due to the adverse effects of the external economic shocks,
at which it was sever for those who depend on export for growth (IMF, 2008).
In spite of the over dependence of low income economies (LIEs) on commodity export, little
attention has been given to the effect of fluctuation on international markets and their dynamics
in developing countries economy specially in mono-crop export countries (Addison and
Ghoshray, 2013). But, recently commodity price fluctuations has become the major concern for
policy makers after commodity price start to show higher volatility since 2008 (Svensson, 2005).
For a small open economy with a significant degree of commodity exports, the international
commodity prices are the major determinants of the economic performance (Mendoza, 1995;
Kose, 2002; Grimes, 2006). These international prices are set to maintain the equilibrium
between international supply and demand. Accordingly, the economic performance of countries
which heavily depends on commodity production is vulnerable to external price shocks (Grimes
and Hyland, 2013).
In Sub-Saharan Africa (SSA) countries, low and unstable economic growth is achieved due to
external shocks such as fluctuations in commodity prices and natural disasters (Raddatz, 2007).
The level of volatility in commodity price has been the main driving factor for economic growth
and the incidence of poverty in LICs. Single or few commodities are substantially exported by
the SSA countries, at which their source of income heavily depends on export of few primary
products. Due to that reason, large fluctuations or shocks to commodity prices can have impact
on individual incomes, which in turn affects the well-being of country’s population (Addison and
Ghoshray, 2013).
Since Ethiopia’s source of income is from exports of primary agricultural products, as to many
LICs, the economy is usually vulnerable to the shock to the commodity prices. In 2008/09,
export earnings declined by 1.2 percent due to the slowdown in international prices of major
export items following the global economic crisis. But later on in the 2009/10 fiscal year the
2
export earnings of coffee increased by 40.6 percent due to a 28.5 percent rise in export volume
and a 9.4 increment in international price. Though, in 2015/16 earnings from coffee export
declined by 7.4 percent as a result of 14.3 percent reduction in international price despite 8
percent rise in volume of export. Surprisingly, revenue from export of coffee started to rise
owing to a 7.5 percentage rise in international price in 2016/17 (NBE, 2017).
Accordingly, the Ethiopian export earnings follow neither an increasing nor a decreasing trend,
which is a function of the shock to the external economies. Volatility in export earnings leads to
uncertainty in foreign exchange inflow which greatly affects economic growth. Therefore, a
research that investigates the effect of commodity price shock on Ethiopian economy is
mandatory in order to cope up the fluctuating global economic conditions and to achieve the
domestic economic goals.
Generally, the literatures on the effect of commodity price shock on economic growth is mainly
built on the side of developed countries only (Hamilton, 2005, 2009; Kilian, 2005; Kilian and
Park, 2009; Iwayemi and Fowowe, 2011). The studies that focus on developing countries are
based on cross country data set, and this paper investigates the effect of external commodity
shock on economic growth by taking, export heavily dependent developing country, Ethiopia as
a case study.
2. Review of related literature
Volatile commodity prices have more or less become a stylized fact in the world economy today.
Countries with commodity production are heavily affected by the fluctuations in international
prices. The greatest issue in the current economic situation for developing countries is their
dependence on commodities for achieving economic growth when their prices are volatile due to
the swings in the international commodity price. In the literature for the commodity price shock,
there are limited research works as it is a new and growing concept. Some cross-country studies
available, but there is limited availability of country specific studies especially on the low
income economies.
Addison and Ghoshray (2013), for instance, assesses the effect of agricultural commodity price
shock on economic growth for 17 selected sub-Saharan African countries using a VAR model
and asymmetric effect of commodity price shock on economic growth is found. Pedersen (2018)
3
also studies how shocks to the copper price affect the economy of Chile using structural vector
autoregressive model and finds positive copper price shock, independently of the source, result
in an appreciated currency. Noha et al. (2015) also examines the impact of commodity terms of
trade (CTOT) index on the real GDP per capita growth in developing countries using a panel of
43 developing countries, employing Arellano Bond “Difference GMM”. The results show that
for all the countries under consideration, an incremental change in commodity term of trade
index has a statistically positive effect on the GDP per capita growth rate. Furthermore, the study
signifies for the improved management in the natural resources of developing countries, better
management is needed in the energy sector to counter the resource curse of countries with a low score on the governance index.
McGregor (2017) estimates the structural and dynamic macroeconomic response of resource
rich, low income countries to global commodity price shock using a panel VAR model and
cholesky decomposition is used to identify the structural commodity price shock for a set of
developing countries. The results implies that a one standard deviation increase in commodity
prices raises per capita income in developing countries by 0.26% and government spending and
investment by 4.4% and 12.4%, respectively. The effects are also found to be larger for less
developed countries, those heavily dependent on commodity exports and economies with fixed
exchange rate regimes.
Bangara and Dunne (2018) investigates the macroeconomic impacts of price shocks in the major
export crop of tobacco for the Malawian economy using structural vector autoregressive model
over the period of 1980Q1 up to 2012Q4. The results indicates that a positive tobacco price
shock has a significant and positive impact on the country’s gross domestic product, negative
effect on consumer price index and induces the exchange rate to appreciate.
Medina (2016) also analyzes the effects of commodity price shocks on fiscal revenues and
expenditures in Latin American countries. The results indicate that Latin American (LA)
countries’ fiscal aggregates rise in response to positive shock to commodity prices, yet there are
marked differences across countries. Similarly, Vallejo (2017) investigates the role of
commodity price shock on the macroeconomic performances and in fiscal outcomes for 8 LA
countries. Depending on the Medina (2010) methodology, a specific commodity index is
generated. To investigate the relationship, panel VAR model based on cholesky identification is
4
employed. Accordingly, commodity price fluctuations results in economic fluctuations in LA
countries and the magnitude of the effect are higher in LA countries than the high income
commodity countries.
Roch (2019) analyzes the macroeconomic effects of commodity price shocks in commodity
exporting countries for a panel of 22 countries by employing heterogeneous panel structural
vector autoregressive. From the results of heterogeneous panel structural vector autoregressive
model, commodity term of trade shock is found to be an important driver of business cycle
fluctuations: 30 percent variation in output is attributed to commodity term of trade shock.
Besides from the results of panel structural vector autoregressive model, inflation targeting
regimes, exchange rate flexibility, and fiscal rules help insulate the economy from commodity
price movements.
Gelos and Ustyugova (2017) studies the inflationary impact of commodity price shock across
countries to a broad range of structural characteristics and policy frameworks over the period
2001-2010, using several approaches. Their finding suggests that economies with higher food
shares in CPI baskets, fuel intensities, and pre-existing inflation levels are more prone to
experience sustained inflationary effects from commodity price shocks. They also state that
countries with more independent central banks and higher governance scores seem to have
contained the impact of these shocks better. The effect of the presence of inflation targeting
regimes, however, appears modest and not evident during the 2008 food price shock. Their
results also suggests that trade openness, financial development, dollarization, and labor market
flexibility do not significantly influence the way in which domestic inflation responds to
international commodity price shocks. Atsushi and Takayuki (2017) also investigate the effects
of commodity price shocks on headline inflation with a cross-country panel and find that the
effects of commodity price shocks on inflation virtually disappear within about one year after the
shock.
Grimes and Hyland (2013) also examines the effect of exogenous commodity price shock on
both urban and rural community outcomes using vector autoregressive (VAR) model for a panel
of New Zealand districts. Taking housing price and housing investment as a proxy for economic
and population outcomes, housing investment and housing price respond positively to
5
commodity price shock across the country. Besides, rural communities are less affected by the
commodity price shock than the urban communities.
Though still limited in number, the literature is mainly built on the developed economies and
cross-country study of developing countries. This paper deviates from the aforementioned
research works as it deals with the effect of commodity price shock for a small open economy,
namely Ethiopia. In addition, it employs the local projection method for the computation of the
impulse response functions which has some advantages over the VAR impulse response
functions.
3. Methodology
3.1. Data type and source
The sample period that is used in the estimation is from 1991Q1 to 2016Q1. To keep the analysis
as parsimonious as possible, we include six variables in our model, namely world commodity
price index, gross domestic product, consumer price index, money supply, foreign exchange
reserve and real effective exchange rate. The data for world community price index is obtained
from international monetary fund (IMF), and national bank of Ethiopia for the rest of the
variables.
3.2. Empirical Approach
Jorda’s (2005) local projection method is used to show the effect of world commodity price
shock on the Ethiopian economy. The local projection method requires running a sequence of
predictive regressions of a variable of interest on a structural shock for different prediction
horizons. The impulse response is then obtained from the sequence of regression coefficients of
the structural shock (Aye and Harris, 2019; Aye, 2019). Therefore, the method can produce the
response of endogenous variables to world commodity price shock at different horizons.
As clearly explained in Auerbach and Gorodnichenko (2013), Ramey and Zubairy (2014), Aye
and Harris (2019), and Aye (2019), this method has some advantages compared to vector
autoregression (VAR) impulse responses. First, the estimation relies on robust standard errors
and is simple to implement. Second, it is robust to misspecification of the data generating
process. Last but not least, impulse responses from the local projection are consistent and
asymptotically normal.
6
The model can be written as follows:
x t +h = α h+φh(L)y t−1+βh shockt+linear trend+ε t+ h (1)
Where x denotes the variable of interest, y represents a vector of control variables, φ(L) is a
polynomial in the lag operator, and shock is the VAR-based world commodity price shock. In
our study, x contains world commodity price index and gross domestic product, y consists lags of
the values of world commodity price index, gross domestic product, consumer price index,
money supply, foreign exchange reserve and real effective exchange rate. The coefficient βh
represents response of x at time t + h to the shock at time t. Hence, one can construct impulse
responses by estimating a set of regressions for each horizon h. We will include a constantα h and
a linear trend in the model.
Impulse response coefficient estimates can suffer from serial correlation, which may lead to
wider marginal error bands. Conditional error bands help remove the variability caused by the
serial correlation. Conditional error bands are consistent with the joint null of significance and
give a better sense about the significance of individual responses. In the absence of correlation
among impulse response coefficients, marginal and conditional bands would be similar (Jorda,
2009). In this paper, therefore, results are produced using the conditional error bands to remove
serial correlation, if any.
Another issue arises regarding the identification of commodity price shock in the local projection
model. The identification of the shock is achieved via the recursive approach. Therefore, world
commodity price index is ordered first followed by gross domestic product, consumer price
index, money supply (M2), foreign exchange reserve and real effective exchange rate.
4. Main results
The impulse response functions over 10 horizons for the effect of commodity price shock on the
Ethiopian economy is given in Figure 1.
7
The commodity price shock is persistent. Most importantly, output responds positively and
significantly to world commodity price shock. Output increases by about 0.05 per cent on impact
in response to a standard deviation shock in commodity price. The joint and cumulative
responses are also statistically significant. This evidence is in line with the findings of Deaton
and Miller (1996), Ben et al. (2018), and Drechsel and Tenreyro (2018) that a negative shock to
commodity price shock adversely affects the level of national output through its effect on foreign
exchange, government revenue and income for household. Similar to the findings of Blomberg
and Harris (1995), Furlong and Ingenito (1996), commodity price shock has also a positive and
significant effect on domestic consumer prices after the first quarter, suggesting the inflationary
effects of commodity prices. Money supply also responds positively and significantly up to the
fourth quarter.
Consistent with the results of Nakatani (2018), foreign exchange reserve increases significantly
from the fourth quarter onwards to an increase in world commodity price, since low commodity
prices creates numerous challenges in resource-rich economies, particularly low-income ones
such as lower export revenues, shortages of foreign reserves, and weakened fiscal positions.
Finally, our sixth variable, real effective exchange rate appreciates on impact insignificantly in
response to the world commodity price shock, for which the same result is also obtained by
Pedersen (2018).
8
Figure 1: Response of endogenous variables to one standard deviation commodity price shock
with 95 per cent conditional confidence bands
9
5. Conclusion
As to many sub-Saharan African countries, Ethiopia heavily depends on primary agricultural
commodities as a major source of income. All of these commodities have been vulnerable to
high price volatility, and as a result, export earnings have been volatile. This has hindered
investment, especially investment in human and physical capital to diversify economies away
from their dependence on primary commodities. Hence, this paper illustrates the effect of
commodity price shocks on the Ethiopian economy over the period of 1991Q1 up to 2016Q1.
While the impulse response functions are computed by local projection method, the commodity
price shock is identified by cholesky decomposition.
The result shows that Ethiopia’s economic growth is significantly affected by the shock to the
commodity prices. Output increases by about 0.05 per cent on impact in response to a standard
deviation shock in commodity price. Domestic consumer price is also positively and
significantly affected by a shock to commodity price after one quarter. The commodity price
shock has also a positive and significant effect, on impact, on money supply. Foreign exchange
reserve increases significantly from the fourth quarter onwards and real effective exchange rate
appreciates on impact, though insignificantly, in response to the increase in commodity price. In
our future research effort, we will try to consider the asymmetric effects of commodity price
shock for this small open economy.
10
References
Addison, T., and Ghoshray, A. (2013). Agricultural Commodity Price Shocks and Their
Effect on Growth in Sub-Saharan Africa. WIDER Technical Report Working Paper
No. 098, World Institute for Development Economic Research (UNU-WIDER).
Atsushi S., and Takayuki T. (2017). "Effects of commodity price shocks on inflation: A
cross-country analysis," CAMA Working Papers 2017-45, Centre for Applied
Macroeconomic Analysis, Crawford School of Public Policy, The Australian National
University.
Auerbach, A.J., and Y. Gorodnichenko (2013). Fiscal multipliers in recession and expansion.
In Fiscal Policy after the Financial Crisis, ed. A. Alesina and F. Giavazzi, 63-98.
Chicago: University of Chicago Press.
Aye C., and L. Harris (2019). The effect of real exchange rate volatility on income
distribution in South Africa, WIDER Working Paper 2019/29.
Aye C. (2019). Fiscal policy uncertainty and economic activity in South Africa: An
asymmetric analysis, UP Working Paper 2019/22, University of Pretoria.
Bangara B.C., and Dunne P. J. (2018). Macroeconomic effects of commodity price shocks in
a low-income economy: The case of tobacco in Malawi, South African Journal of
Economics Vol. 86, no. 1, 53-75.
Ben Z., N., Pappa, E., and Vicondoa, A. (2018). Emerging economies business cycles: The
role of commodity terms of trade news. Journal of International Economics, 108,
368–376.
Blomberg, S. B., and Harris, E. S. (1995), “The Commodity-Consumer Price Connection:
Fact or Fable?”, Federal Reserve Bank of New York Economic Policy Review, pp.
21-38.
Deaton, A., and Miller, R. (1996). International commodity prices, macroeconomic
performance, and politics in Sub-Saharan Africa. Journal of African Economies, 5(3),
99–191.
Drechsel, T., and Tenreyro, S. (2018). Commodity booms and busts in emerging economies.
Journal of International Economies, 112, 200–218.
11
Furlong, F., and Ingenito, R. (1996), “Commodity Prices and Inflation”, Federal Reserve
Bank of SanFrancisco Economic Review, no. 2, pp. 27-47.
Gelos, G., and Ustyugova, Y. (2017). "Inflation responses to commodity price shocks – How
and why do countries differ?," Journal of International Money and Finance, Elsevier,
vol. 72(C), pages 28-47.
Grimes, A. (2006). “A Smooth Ride: Terms of Trade, Volatility and GDP Growth”, Journal
of Asian Economics 17:4, pp. 583–600.
Grimes, A., and Hyland, S. (2013). “Passing the Buck: Impacts of Commodity Price Shocks
on Local Outcomes”, Motu Working Paper 13-10.
Hamilton, J. D. (2005). Oil and the Macroeconomy. In J.-R. Rebeca and M. S’anchez (eds),
The New Palgrave Dictionary of Economics. London: Palgrave Macmillan, 201–228.
Available at: http://www.dictionaryofeconomics.com/ dictionary.
Hamilton J.D. (2009). Causes and Consequences of the Oil Shock of 2007-08. Technical
Report No. 15002, National Bureau of Economic Research.
IMF (2008), Poverty and Social Impact Analysis by the IMF: Review of Methodology and
Selected Evidence, Washington, DC: IMF.
Iwayemi, A., and Fowowe, B. (2011). Impact of oil price shocks on selected macroeconomic
variables in Nigeria. Energy Policy, 39: 603-612.
Jorda, O. (2005). Estimation and inference of impulse responses by local projections. The
American Economic Review, vol. 95, no. 1, pp. 161-182.
Jordà, Ò. (2009). “Simultaneous Confidence Regions for Impulse Responses,” Review of
Economics and Statistics, v. 91 (3), pp. 629–647.
Kilian, L. (2005). The Effects of Exogenous Oil Supply Shocks on Output and Inflation:
Evidence from the G7 Countries. Technical Report No. 5404, CEPR Discussion
Papers.
Kilian, L., and Park, C. (2009). The impact of oil price shocks on the US stock market.
International Economic Review, 50: 1267-1287.
Kose, M. A. (2002). “Explaining Business Cycles in Small Open Economies – ‘How Much
do World Prices Matter?’”, Journal of International Economics 56:2, pp. 299–327.
12
McGregor T. (2017). Commodity price shocks, growth and structural transformation in low-
income countries, the quarter review of economic and finance,
http://dx.doi.org/10.1016/j.qref.2017.01.006.Medina, L. (2010), ‘The dynamic effects of commodity prices on fiscal performance in Latin
America’, Working Paper WP/10/192, International Monetary Fund.
Medina L. (2016). "The Effects of Commodity Price Shocks on Fiscal Aggregates in Latin
America," IMF Economic Review, Palgrave Macmillan; International Monetary
Fund, vol. 64(3), pages 502-525, August.
Mendoza, E. G. (1995). “The Terms of Trade, the Real Exchange Rate, and Economic
Fluctuations”, International Economic Review 36:1, pp. 101–37.
Nakatani, R. (2018). Adjustment to Negative Price Shocks by a Commodity Exporting
Economy: Does Exchange Rate Flexibility Resolve a Balance of Payments Crisis?,
MPRA Paper No. 87153.
NBE (2017). Annual Report of Ethiopian Macroeconomic Performance.
Noha E., Amon S., and Tricia J. (2015). Commodity price changes and economic growth in
developing countries, MPRA Paper No. 68678,
https://mpra.ub.uni-muenchen.de/68678/.Pedersen, M. (2019). The impact of commodity price shocks in a copper-rich economy: the
case of Chile. Empir Econ 57, 1291–1318 doi: 10.1007/s00181-018-1485-9.
Raddatz, C. (2007). ‘Are External Shocks Responsible for the Instability in Low Income
Countries?. Journal of Development Economics, 84: 155–87.
Ramey, V.A., and S. Zubairy (2014). Government spending multipliers in good times and in
bad: Evidence from U.S. historical data, NBER Working Paper, no. 20719.
Roch F. (2019). The adjustment to commodity price shocks, journal of applied economics
2019, vol. 22, no. 1, 437–467.
Svensson, L. E. O. (2005), Oil prices and ECB Monetary Policy, manuscript,
www.princeton.edu/svensson/papers/ep501.pdf.
Vallejo, P.L. (2017). Assessing the effect of commodity price shocks in the macroeconomic
performance and fiscal outcomes in Latin America countries, Cuestiones Económicas
Vol. 27, No. 2:2, 143-170.
13