Commodity Currencies

• Author: Paul Cashin, Luis Céspedes, and Ratna Sahay
• Position: Senior Economist/Economist in the IMF's European I Department/Assistant Director in the IMF's Research Department

Developing countries reliant on commodity exports see the fate of their exchange rates tied to fickle commodity markets

For decades, economists have tried with little success to model long-run movements in real-that is, adjusted for inflation-exchange rates. Almost all of the studies have focused on industrial countries, trying to pinpoint whether fundamentals such as government spending, current account imbalances, and differences in productivity and interest rates hold the key to explaining exchange rate movements. But the results have been disappointing, with many models that are based on fundamentals failing to provide a convincing explanation of the behavior of real exchange rates in industrial countries.

In contrast, studies of the behavior of developing country real exchange rates are scarce. The few studies that have examined the determinants of these rates have focused largely on Latin America and have emphasized the role of terms of trade movements in driving the real exchange rate. However, a natural assumption for developing countries is that fluctuations in real commodity prices have the potential to explain a large share of changes in real exchange rates, given that so many of these countries are highly dependent on commodities-in some cases, a single commodity-for the bulk of their export revenues. Indeed, several studies have explored this relationship for a handful of commodity-exporting industrial countries, such as Australia, Canada, and New Zealand. But the biggest hurdle in extending these studies to developing countries has been the lack of country-specific data on commodity export prices.

That is why we undertook a study of the relationship between the real exchange rate and real commodity prices for all commodity-dependent economies. We asked two questions: Do real commodity prices and real exchange rates move together? And does the exchange regime affect a country's ability to cope with commodity price swings? The findings are surprising and raise serious questions for policymakers, given that the real exchange rate holds the key to a country's competitiveness in global trading markets.

Identifying commodity currencies

Our study began with the construction of new monthly indices of national real commodity export prices and the gathering of monthly real exchange rate data for 58 commodity-exporting countries for the period January 1980 to March 2002. Each country's (nominal) commodity export price index is a geometric weighted average of world prices for 44 individual nonfuel commodities (taken from IMF commodity price data), using country-specific export shares (averaged over 1990-99) as weights. The national indices of the nominal (U.S. dollar) price of nonfuel commodity exports are then deflated by the IMF's measure of the nominal (U.S. dollar) price of exports of manufactured goods to form the real price of commodity exports for each country. The real price of commodity exports can also be described as a measure of the terms of trade of each country, expressed in...