w__s ___I)

POLICY RESEARCH WORKING PAPER 1600

Is Commodity-Dependence Commoditydependencedoes not necessarily lead to

Pessimism Justified? low income and export

growth. Government policies

Critical Factors and Government that encourage dynamic and

viable commodity sectors

Policies that Characterize Dynamic include:

Commodity Sectors a Eliminating price controls

and state monopolies.

Nanae Yabuki a Promoting research and

Takamasa Akiyama extension.a Developing transport and

communications

infrastructure.

a Enticing foreign capital

and technology transfers.

- Establishing a legal

system that encourages the

use of innovative financial

instruments.

The World BankInternational Economics DepartmentCommodity Policy and Analysis Unit aMay 1996

P PoLIcy RESEARCH WORKING PAPER 1600

Summary findings

Economists often associate a country's dependence on Drawing on successful cases - including Uganda's

primary commodities for exports, income, and coffee sector, Ghana's gold mines, and Colombia's cut-

employment with underdevelopment and low income. flower industry - Yabuki and Akiyama identify

Yabuki and Akiyama explore this commodity pessimism government policies that encourage viable commodity

theoretically and empirically and suggest that it may be sectors. These include:

ill-founded. If it is, it could have adverse ramifications * Eliminating price controls and state monopolies.

for many commodity-dependent developing countries. * Promoting research and extension.

They examine successful commodity-exporting * Developing sound infrastructure in transport and

countries and show that commodity dependence does communications.

not necessarily 'ead to low income and export growth. * Enticing foreign capital and technology transfers.

Successful commodity-exporting countries achieve - Establishing a legal system that encourages the use

dynamic and viable commodity sectors by implementing of innovative financial instruments, especially risk

appropriate policies that encourage private sector management instruments and a sound warehouse receipt

initiative and investment. system.

This paper - a product of the Commodity Policy and Analysis Unit, International Economics Department - is part of a

larger effort in the department to analyze commodity policies in developing countries. Copies of the paper are available

free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Grace ilogon, room N5-032,

telephone 202-473-3732, fax 202-522-3564, Internet address gilogon@worldbank.org. May 1996. (40 pages)

The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about

development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. Thepapers carry the names of the authors and should be used and cited accordingly. The findings, interpretations, and conclusions are theauthors' own and should not be attributed to the World Bank, its Executive Board of Directors, or any of its member countries.

Produced by the Policy Research Dissemination Center

Is Commodity-Dependence Pessimism Justified?

Critical Factors and Government Policies that CharacterizeDynamic Commodity Sectors

by

Nanae Yabuki and Takamasa Akiyama

I

TABLE OF CONTENTS

Introduction 1

I Basis for Commodity Pessimism 3

II Salient Features of successful Commodity Exporting Countries 10

-Export Structure of Successful Commodity-Dependent Countries 10

-Investment in Commodity Sector Development 16

-Foreign Capital and Technology Transfers 19

-Enabling Environment to Increase Investment 22

m Policies Promoting Viable Commodity Sectors 24

-Eliminating Market Controls and Dominant State-Owned Enterprises in the

Market 24

-Enticing Foreign Capital and Technology Transfers 29

-Promoting Research and Extension 31

-Developing Good Infrastructure in Transport and Communication 34

-Establishment of Legal System for the use of Innovative Financial

Instruments and System 35

IV Conclusion 40

Appendix 42

Reference 43

I

INTRODUCTION

Dependence of a country on primary commodities in terms of exports, income and

employment is often associated with underdevelopment and low income. Global

Economic Prospects and the Developing Countries of 1996 (GEP96) found that many

commodity-dependent countries have lagged in the global integration which, in turn, is

closely related to low income growth. Pessimism surrounding commodity dependence

has existed since the 1950s. This pessimism gained renewed prominence in recent years

when commodity prices experienced an historically bad price collapse in the 1980s and

the World Bank Non-fuel Commodity Price Index declined by 25 percent in nominal and

50 percent in real terms (nominal prices deflated by the Bank's unit export value index of

manufactures exported by the G-5 countries (MUV)) between 1980 and 1993.

The policy ramifications of this pessimism for commodity-dependent developing

countries might be significant. As was the case with a number of Latin American

countries after Prebisch-Singer Thesis first appeared, today in response to this pessimism

governments of many commodity-dependent countries might implement strong anti-

commodity, pro-industry policies without duly considering the comparative advantage

these countries possess. Such policies are lik9ly to fail, as many of the import

substitution policies taken by the Latin American countries did. Additionally, these

policies tend to re-enforce other policies in commodity-dependent countries that already

tend to have an urban bias. Because of these policy ramifications, the commodity-

dependence pessimism warrants examination in some depth both theoretically and

empirically.

In spite of wide-spread commodity pessimism, there are a number of commodity-

dependent countries that have achieved high total merchandise export and per-capita

income growth through commodity exports. There are, also, many cases in which

1

individual commodity subsectors showed spectacular production and export growth in

developing countries. These cast some doubts on the validity of commodity-dependence

pessimism.

The main focus of this paper is to examine this pessimism regarding commodity

dependence by identifying factors that have contributed to recent successful cases of

commodity export and production in developing countries. This examination suggests

that the commodity dependence per-se does not cause low income and export growth.

Dynamic and viable commodity sectors result from high level of investment which, in

turn, is due to government policies that create enabling environment under which the

private sector is innovative and invests. Section I examines the theoretical basis for

commodity pessimism and evaluates it in light of recent developments in the world

commodity markets. Section II identifies the salient features of successful commodity

exporting countries. Section III distinguishes key government policies that have

contributed to successful commodity sector developments drawn from a number of

concrete recent cases in commodity sectors, and Section IV summarizes the conclusions.

2

I. Basis for Commodity Pessimism

The thesis that a commodity-dependent country will face slow economic growth

has been in circulation at least since the Prebisch-Singer Thesis appeared in the 1950s.

The basic argument was that income elasticities of demand for commodities is low

making it difficult for commodity-dependent countries' to export and, hence, economnies

to grow fast. This thesis had an important impact on the policy makers of many Latin

American countries and led to these countries adopting import substitution policies, the

results of which were disappointing. Since the 1950s, several thesis and explanations

have surfaced supporting the pessimism including declining commodity prices,

arguments by Hausmann and Gavin, and Sachs and Warner, the Dutch disease and the

adding-up problem. It is questionable, however, whether these thesis and explanations

are valid in view of recent developments in the world commodity markets and their

prospects.

One basis for commodity pessimism stems from the long-term trend of

commodity prices. Whether commodity prices in relation to manufactured goods prices

have been declining or not has been hotly debated (see, for example, Grilli and Yang

(1988)). The large price decline of the 1980s appears to support the pessimists.

A recent study by Hausmann and Gavin (1995) identified commodity price

volatility as one culprit that hinders economic development of commodity-dependent

countries. They infer that volatile world commodity prices cause volatile export revenues

in commodity-dependent countries and that this adversely impacts these countries'

economies in a number of ways, the worst of which are the effects on investment and on

government deficits. The argument is that risk-averse investors become hesitant to invest

in sectors which are fraught with uncertainty. Also, volatile commodity export revenues

cause government revenues to fluctuate widely, which in turn tend to increase

government deficits and, hence, national external debts.

3

Sachs and Warner (1995) found a statistically significant, inverse association

between natural resource intensity and economic growth. They report that their finding is

consistent with the view that the key division that matters for endogenous growth effects

is manufacturing or traded manufacturing versus natural resources.

There are two other widely known explanations for the slow income and export

growth of commodity-dependent countries--the Dutch disease and the adding-up problem.

Dutch disease results from commodity booms and busts that are extreme cases of

commodity price volatility. Dutch disease's main negative impact on an economy is a

significant appreciation of the currency when a commodity boom results in large

unanticipated foreign exchange inflows. This appreciation then adversely impacts non-

booming export and import-substitution sectors. When the boom finally ends, the

country is worse-off than before the boom because it ends up with much weaker tradable

industries that did not boom while the once-booming industry has gone bust.

The adding-up problem is essentially one related to low price elasticity of demand

for commodities but also, in a practical sense, to low income elasticity of demand. It is

based on an economic theory that says when the demand is not increasing, the revenue

from a commodity with low price elasticity of demand will fall when supply is increased.

This occurs because the additional supply causes price to fall proportionately more than

the increase in supply. The significance of adding-up problem is that it is not possible for

all the commodity-dependent countries to achieve high export growth because when the

world export volume of commodities with low price and income elasticities is increased,

the aggregate export revenues of these countries will decline rather than increase.

If the commodity-dependence pessimism discussed above is valid, then it bodes ill

for commodity-dependent countries which comprise many developing countries as many,

if not most, of these countries are likely to remain commodity dependent for some time.

However, if such pessimism is not well-founded, commodity dependent countries would

be ill-advised to take policy decisions based on its influence. The pessimism could very

4

well impel policy makers of these countries to adopt anti-commodity, pro-industry

policies without giving due consideration to the comparative advantage these countries

possess. Because such policies tend to be interventionist and to have urban bias, they

might destroy the main, if not the only, engine of economic growth.

There are, in fact, some valid doubts whether commodity pessimism is justified.

For one, the recent wave of commodity pessimism appears to be based on the analysis of

data of the last 15 years or so, a period when commodity prices experienced one of the

worst price collapses in history. (see Figure 1). The impact of this price collapse on

developing countries' export revenues is estimated to be about US$26 billion a year in

1990 constant terms (see Table 1). Also, the correlation between the shares of

commodities in total exports, and total merchandise exports and per capita GDP is

significantly negative for the period 1981- 1992, but it is much less significant for data for

the period 1970-1980 (see Table 2). Hence, it is likely that the recent commodity

pessimism is strongly influenced by the price collapse of the 1980s. Moreover, it is

unlikely that commodity prices will continue their sharp price decline. In fact, many

commodity prices showed significant increases in 1994 and 1995 (see, for example,

World Bank (1995)), suggesting that the recent commodity pessimism has been

exaggerated.

5

ii NO-8 ¢° ° N X v °

x~: a o N 8 w

Table 1: Effect of Price Decline on Commodity Export Revenues of Developing Countries

Average Average Change between Price Quantity andCommodities 1981-1982 1991-1992 1981/82-91192 Effect at Cross Effects a/

---- (1990 US$ Million)----Coffee 11,812 5,641 -6,171 -7,524 1,353Cocoa 3,798 2,252 -1,546 -2,226 680Tea 2,019 1,767 -252 -668 416Sugar 4,816 2,646 -2,170 -1,522 -648Bananas 1,867 2,780 913 -155 1,068Cereals 11,905 8,512 -3,393 -5,441 2,048Fats & Oils 8,488 9,613 1,125 -3,633 4,758Cotton 6,125 3,701 -2,424 -2,499 75Rubber 4,008 3,227 -781 -1,659 878Tobacco 3,554 3,342 -212 -85 -127Aluminum 3,052 4,651 1,599 -671 2,270Nickel 1,231 1,705 474 -39 513Total 62,675 49,837 -12,838 -26,123 13,285

a/ Percentage change in export revenues can be decomposed into percentage changes in price,

quantity, and cross effects. Mathematically, AER/ER = A % + A Q + AP.AQ where ER =P ~ER

Export Revenue, P = Export Price, Q = Export Quantity and A signifies the change. The threeterms in the RHS of the equation are price, quantity and cross effects.Source: International Economics Department, World Bank.

Table 2: Correlation Coefficients Between Commodity Shares in Total Exports and GDP perCapita and Total Export Growth

1970-1980 1981-1992

GDP per capita growth -0.21 -0.37

Total merchandise export growth in real terms(Deflated by MUV) -0.16 -0.58

Note: Commodity shares are for the ending years. Country samples are 67 LMICs for GDP per capitagrowth calculation, and 43 and 39 LMICs for total merchandise export growth calculations for theperiods 1970-1980 and 1981-1992 respectively. Sample numbers vary because of availability of data.Source: International Economics Department, World Bank.

Declining commodity prices do not necessarily imply declining profitability of

commodity exports. An examination of specific cases suggests that increases in

productivity and in marketing efficiency, achieved by many commodity producing

countries, have resulted in increasing in profitability from commodity production in these

countries. This implies that countries that were not able to increase productivity in

7

commodity production and efficiency in marketing experienced large losses from price

declines. However, such a situation is not particular to commodities but is even more

prominent in fiercely competitive markets of manufactured goods.

Further evidence that challenges the pessimism is the several commodity-

dependent countries that succeeded in increasing their commodity export revenues and

GDP per capita in spite of the commodity price collapse of the 1980s, e.g., Chile,

Indonesia, Malaysia, and Thailand. These countries achieved this by developing non-

traditional, fast-growing commodities, including processed goods, as well as by

increasing productivity of traditional commodities.

With regard to Dutch disease and the adding-up problem, recent studies argue that

these problems, although associated with commodity-dependence, are not unavoidable.

According to a recent World Bank paper by Varangis et al. (1995)), Dutch disease can be

effectively avoided by commodity-dependent countries with the adoption of appropriate

policies. Many countries have actually succeeded in alleviating the effects of the disease

just by so doing. With regard to the adding-up problem, Akiyama and Larson (1994)

argue that the problem is often exaggerated and that, at the individual country level, only

a small number of countries with a very limited number of commodities experience

proportionately small or declining export revenues when export volume of commodities

is increased.

The discussions above suggest that it is not commodity dependence per-se that

hinders export and income growth. While it is true that demand for traditional

commodities has grown very slowly, recent growth in exports by developing countries of

both non-traditional and processed commodities indicate that there is ample scope for

further growth through market penetration. The Uruguay Round and the general world

trend toward trade liberalization could make it easier for developing countries to

penetrate into the markets of these commodities in industrialized countries. Also, recent

high income growth in many developing countries, notably China, appears to have

8

changed world commodity markets significantly by enlarging the world market for

commodity consumption. This trend could be enhanced if India's income increases

rapidly and FSU's economies recover.

9

II. Salient Features of Successful Commodity Exporting Countries

As discussed in the previous section, several commodity-dependent countries

have achieved high export and income growth defying commodity pessimism. An

examination of these countries reveals that they became successful by accomplishing one

of the following: (i) development of non-traditional, fast growing commodities; (ii)

productivity growth in traditional commodities; or (iii) development of high value-added

commodities. A feature that distinguishes successful commodity exporting countries

from unsuccessful ones is the level of investment in the commodity sector, including that

by foreign firms. One important element that affects investment is the extensiveness of

the enabling environment. In this context, the economies of successful commodity

exporters have been much more stable and open than the unsuccessful ones.

Conversely, a review of unsuccessful commodity-dependent countries shows that

they retain traditional production, marketing, and export systems, often carried over from

the colonial period. In agriculture, a traditional system usually entails production

undertaken by small producers with limited resources and education and with pricing,

marketing, and export systems that are government-controlled and non-competitive. A

major problem with such systems is that they provide very limited scope for producers

and traders to exert initiative or to introduce innovations. Such systems often stifle them

and provide almost no process for learning. For example, in the mining sector of many

unsuccessful commodity-dependent countries, most mines are either large state-controlled

enterprises or artisanal and there are only a very limited number of mid-sized mining

firms. Neither of the two main categories of mining concerns provide significant

opportunity for learning or technological improvements.

Export Structure of Successful Commodity-Dependent Countries

Commodity-dependent countries have varied widely in their capacity to increase

diversification and productivity as evidenced by the composition of their export growth in

real terms over 1972-92. Figure 2 shows the difference in the commodity export

10

performance in the last two decades between the successful commodity-dependent countries

and the unsuccessful ones, which essentially overlap the countries classified as lagging

integrators in GEP96.1 The four successful commodity-dependent countries in Figure 2-

Chile, Indonesia, Malaysia and Thailand-experienced spectacular growth in non-

traditional exports, such as fruits, vegetables and shrimp, and steady growth in other

agricultural categories. By contrast, the lagging integrators, excluding oil exporters, made

little headway in non-traditional exports (shrimp is a partial exception).

Processing of commodities to intermediate and final goods has been considered as

an important way for commodity producing countries to increase the value of their exports.

Successful commodity-dependent countries, such as the four above, have expanded exports

of processed commodities substantially in recent years. One such example is Thai boneless

chicken discussed in Box 1. In addition to its value-added effect, the processing of

commodities has other advantages, a main one of which is making export revenue more

stable because the price volatility of processed goods tends to be much smaller than that of

primary commodities (see Yeats (1993)).

Country classification by the speed of integration is given in Appendix.

11

Box 1: Thai Boneless Chicken that Flew

The international trade in chicken meat has been increasing dramatically, particularly notable isprocessed chicken meat by some developing countries. The worldwide import of poultry meat2 increasedfrom US$ 509 million in 1980 to US$5.3 billion in 1993. The world import demand for chicken meat isconcentrated in a limited number of markets: the Middle East (mainly Saudi Arabia), Asia (mainly Japan)and EU (intra-EU). The main importers are Japan (US$704 million)3 , Germany (US$521 million), SaudiArabia (US$414 million), Hong Kong (US$ 315 million), and the Netherlands (US$126 million). The mainexporters are the US (US$799 million), the Netherlands (US$633 million), France (US$617 million), Brazil(US$566 million), Thailand (US$351 million) and China (US$174 million).

Thailand has recently succeeded in entering into this growing market as a major exporter bydeveloping a poultry processing industry. Its chicken meat exports had increased from practically nil in themid-1970s to 157,000 tons in 1993, when exports of chicken meat accounted for US$351 million. About98% of chicken meat exports from Thailand are processed meat for the Japanese market. One of the majorreasons for this success is that Thailand can process chicken at a cost considerably lower than that of othermajor exporting countries. Although the cost of feed in Thailand is not the lowest, Thailand has the costadvantage in this labor-intensive process because of its low labor cost.

During the early 1970s, several Thai feed milling enterprises merged and expanded into poultryproduction. They developed contractual ties with existing producers and built slaughterhouses and modernprocessing facilities to produce value-added chicken cuts that met consumers' taste in Japan. They importedtechnology from foreign investors in the areas of genetics, nutrition, and disease control and also obtainedtechnical assistance and capital from those investors. The Government offered investment incentives andresearch and quality control services. Thailand also adopted the streamlined vertically-integratedproduction, processing and overseas distribution systems developed by Japanese companies. As a result, theThai processed chicken meat industry became one of the largest, most cost efficient and most technicallyadvanced processed meat industries in the world.

The global import demand for chicken meat is likely to continue to grow, mainly because of thesupply problems created by land and environmental constraints and because of income growth in theimporting countries. In some major importing countries such as Japan and Hong Kong, it has becomeincreasingly difficult for local producers to meet consumption demand due to the high cost of production andto environmental problems. The world chicken meat markets are likely to become increasingly competitivewith new exporters because technology inputs required to develop the industry are readily accessible and thetransfer of this technology is relatively easy and rapid. Thus, in addition to the basic requirements of theavailability of low cost feed ingredients, land, labor and transportation, efficiency in processing andmarketing has become increasingly the key factor to enter or stay in this export market.

2 Chicken was dominant in poultry meat trade (86%) followed by turkey (10%) in 1993.3 Figures in brackets are for 1993 unless specified otherwise.

12

Exports of Chicken Meat from Thailand

200000

150000-

o 100000 o

50000

oX u) W LO r 0)}

Years

Source: FAO

Many successful commodity exporters in recent years developed processing

industries through the establishment of joint ventures between foreign and domestic firms.

This trend is particularly evident in a number of Asian countries, such as Indonesia and

Thailand, where intermediate cocoa products, canned fish and fruits, and shrimp with

coating ready to be fried have become important export items. Thanks to the foreign

partners in such undertakings, these products have been marketed through efficient

channels, often up to the retail level where prices are much more stable. This type of

marketing arrangements is especially prevalent with the Japanese FDI in Asia.

In addition to their ability to develop new export commodities, successful commodity

exporters achieved high export growth in traditional products, such as sugar and fats/oilseeds,

while exports of traditional commodities by unsuccessful commodity exporters, proxied by the

lagging integrators, actually regressed. This is evident from the difference in export

performances of the two groups of countries for the period 1972-1992 (see Figure 2). This

difference was mainly a result of the difference between the two groups of countries in

productivity growth with respect to such commodities.

13

Figure 2: Difference in Commodity Export Performances

Divergent Performance of Commodity-Reliant from 1972 to 1992

ael Annual Growth Rate15.0 -..

10.0

5.00 - Intecritor

0.00 C3F cur Suoces sf iI

GomTrrltvEximrters

-5.00

Td*d Fds&lserdT tdFisherv Frults& Suc= ShIrlrAerlaitLe PrcLjds v%Octeds

Commodlty

Note: The Selected Successful Countries are Chile, Indonesia, Malaysia, and Thailand.Source: International Economics Department, World Bank

One group of prominent commodities developed as major exports by successful

commodity-dependent countries is horticultural products; fruits, vegetables and cut

flowers (see Box 2). An examination of how these commodities became important

exports for these countries reveals the underlying factors that distinguish the two groups

of countries.

14

Box 2: Horticulture Products--Booming New Agricultural Commodities

The primary reasons for the recent rapid growth in horticultural trade are the increased demand fromconsumers with rising income in urbanizing industrialized countries, the high cost of production in these countries,the development of lower cost transportation and communication, and the transfer of production and marketingtechnology to developing countries from industrialized countries. These factors have enabled some successfuldeveloping countries, which are able to take advantage of the changing world commodity markets and technologiesavailable, to penetrate the horticultural markets in industrialized countries, supplying goods at competitive pricesmainly during off-season in the importing countries.

The global trade of fresh vegetables and fruits has been growing rapidly. Between 1985 and 1994 theworld import value of fresh and simply preserved vegetables increased from US$8.2 billion to US$18.8 billion andfresh and dried fruits and nuts grew from US$12.3 billion to US$24.2 billion. In 1994, the total value of theseimports was about twice as much as the export value from developing countries of coffee, the single most importantagricultural commodity of developing countries in terms of export value. The major exporting countries ofvegetables are the US (US$1.78 billion in 1994), China (US$1.42 billion), Mexico (US$1.26 billion) and Thailand(US$738 million).

World cut flower exports increased from US$1.25 billion in 1985 to almost US$4 billion in 1993. In thatyear, the world's largest exporter was the Netherlands with exports of US$2.2 billion followed by Colombia withUS$382.5 million. Other major flower exporters among developing countries are Mexico, Costa Rica, Thailand,Kenya and Ecuador.

The horticultural market is competitive mainly because unlike tropical products, the developing countryexporters must also compete with industrial country producers. Horticultural trade also requires sophisticatedmarketing skills. In order to deliver perishable goods, in addition to good transport and communicationinfrastructure, efficient organization and management of these systems are indispensable. Also required areinformation and skills necessary to penetrate markets often protected by complicated tariff and non-tariff barriers,including quarantine regulations.

Horticultural exports by developing countries in this market is likely to continue to grow due to the increasein demand from industrialized countries, advancement in technologies and the likely reduction of trade barriers.The increase in import demand will come not only from higher income and further urbanization but also fromdecline in the agricultural labor force which reduces domestic supply in industrialized countries. Production andmarketing technologies, possibly with contributions from abroad, are likely to reduce costs and hence increase thecompetitiveness of developing countries, many of which have just entered into this growing market.

The significant market penetration by successful commodity exporters into the

world horticultural markets stems from their ability to capitalize on business opportunities

presented. As non-traditional agricultural commodity trade in industrialized countries was

liberalized and as development of transport and communication systems made it feasible

for developing countries to export these commodities to industrialized countries at

competitive prices, successful commodity exporters developed production and marketing

15

and marketing systems to do that. Analysis of the composition of commodities exported

in the last two decades suggests that unsuccessful commodity exporters, however, were

not able to take advantage of the changing world commodity markets and technologies

available.

Investment in Commodity Sector Development

Investment in capital stocks, technology and infrastructure is one of the important

factors which contributes to increases in productivity of traditional commodities and to

development of non-traditional commodities. Figure 3 shows the differences between

fast and slower integrators in the average growth rates of income, investment and fixed

capital stock for agriculture and the economy as a whole.2 As can be seen from the

figure, the capital stock per capita for agriculture actually declined on average in poorly

integrated countries between 1980 and 1990. The average growth rate of the capital stock

for the economies as a whole of these countries was meager on a per capita basis. This

probably was the primary reason for the decline in the per capita agricultural income in

the poorly integrated economies during the 1980s. One reason for this low level of

capital stock in the agricultural sector of many of these countries was the limited credit

for investment made available to the sector by financial institutions. Given the

dependency of the poor integrators on agriculture, it is not surprising that the decline in

agricultural stock per capita was associated not only with the decline in agricultural

income, but with the decline in overall per capita income as well.

2 The data is simple averages taken from the total of 51 countries. The fixed capital investment data usedtypically includes investments on machinery and buildings but excludes investments in livestock.

16

Figure 3: Growth in capital stock and per capita income (1980-90)

Per capita growth in output, capital, and investmentpercent per annum

3.00 -

20

0 [11 - |~~~~~~~~~~~~~~~~~~~~~~~~~~~ Moderate. weak or lailggn

-2.(X)

-3.MX)

-40)Total GDP Total Total Agncultural Agncultural Agricultural

investment cupital GDP mvestment capitalsLock stock

Source: International Economics Department, World Bank

The difference in the level of investment between the successful and the

unsuccessful commodity-dependent countries also can be observed in their mining

sectors. In contrast to very large inflows of private capital into mining projects in Latin

America and Asia in recent years, few investments have been made in Sub-Saharan

Africa (SSA), which comprises many unsuccessful commodity exporters. A recent study

by the World Bank (1994) shows that while countries with major mining sectors invest up

to 10 percent of production value in exploration, many SSA countries attracted

investment of only about 1 percent of production value (see Table 3). The study

concludes that for these countries even modest levels of growth (5-10 percent) would

require new investments of from $US 0.75-1.5 billion per year.

Table 3: Estimated Average Annual World Mineral Exploration Expenditure 1980-89/a(US$ million 1989 terms)

Australia 560Canada 600U.S.A. 360Republic of South Africa 180Sub-Saharan Africa 100Others 700

Total 2,500/a Excludes USSR and Eastern EuropeSource: World Bank (1992)

17

The productivity of a given stock of capital, as well as the expected return from

new investment and, hence, the propensity to invest is determined by multiple factors

including physical infrastructure. Figure 4 provides indicators of basic physical

infrastructure in different groups of countries. As the figure shows, weak and lagging

integrators tend to have weak infrastructure. Poor infrastructure in these countries also

contributed to high marketing costs which lowers competitiveness in the world market.

Furthermore, because poor infrastructure lowers the efficiency of already low levels of

capital stock, it is likely that weak infrastructure has discouraged investment in these

countries. In addition, key infrastructure, especially transportation and communication,

has become increasingly important for commodity-dependent developing countries that

would enter into the new and growing world commodity markets, such as the

horticultural market.

Figure 4: Comparison of Infrastructure Among Three Groups of Countries

a:Electric Power Production (1992) b.Telephone Mainlines (1992) c:Paved Road Densit (1992)

1600 120 - 2500

1400 C 100 a 200001200 0E2

c 80 0. ) 1500.- 800 o60

0. 600 40 5000400 a~~~~~~4

200 a. 20E0 0 0

I~~~~~~~~~~~~~~~~~~~~~~~~

Source: World Bank

As observed in Figures 3 and 4, capital accumulation and income growth is

strongly correlated as well as the level of physical infrastructure and integration into the

global economy. Although investment is indispensable in achieving a dynamic

comimodity sector, many cornmodity-dependent countries face difficulty in generating

sufficient funds to increase their capital stock or in building strong physical infrastructure.

18

Consequently, many unsuccessful commodity-dependentIcountries tend to experience a

vicious circle which spirals down between limited resources for investment and low

production growth due to lack of investment. Assuring an adequate flow of investment

into these countries is made difficult by a number of factors including low savings rates,

inappropriate policy environments, poor regulatory frameworks and weak financial

systems. Raising capital through public equity or bond markets is usually not an option in

these countries.

Foreign Capital and Technology Transfers

One prominent way developing countries have obtained capital and technology in

recent years was through foreign firms often in the form of foreign direct investment

(FDI). This has been especially the case with the development of many dynamic and fast-

growing non-traditional commodity exports of successful commodity exporters. Findlay

(1978) points out that FDI increases the rate of technical progress in the host economy

through a "contagion" effect from the more advanced technology, management practices,

etc. used by the foreign firms. In addition, a recent study by Borensztein, Gregoril and

Lee (1995) highlighted the fact that FDI has the effect of increasing total investment in

the economy beyond that created by FDI itself, suggesting the significance of collateral

effects on domestic firms. One of the advantages FDI has is that it bypasses weak

financial intermediaries and brings capital, expertise and technology directly to the areas

of economic opportunities.

FDI has had significant impact in several commodity sectors in commodity-

dependent countries. Examples include copper in Chile, diamonds in Botswana, gold in

Ghana and Peru (see Box 3), and horticultural products in a number of countries (see

section below on "Enticing foreign capital and technology transfers"). FDI also has had a

positive effect on traditional crops, including high-valued, specialty Arabica coffee in

Indonesia and coffee extracts in Colombia. The liberalization of agricultural sectors has

enhanced the role of FDI in countries that had not attracted FDI before, such as cotton

ginneries and coffee processing in Tanzania, and coffee processing in Uganda.

19

FDI by multinational corporations (MNCs) is considered to be a major channel of

access to advanced technologies by developing countries since MNCs are among the most

technologically advanced of firms, accounting for a substantial part of global research and

development investment. FDI by Japanese MNCs in Asian countries is a prominent

example. Japanese MNCs bnrng most of the input materials as well as production,

processing and marketing systems to host countnres in order to both produce and export

products that match the particular tastes of Japanese consumers. These products are, in

most cases, exported exclusively to the Japanese market through marketing channels,

often arranged up to the retail level by Japanese investors. Shrimp in Thailand, China and

Indonesia; vegetables in China; and tinned fruits in Malaysia, Thailand, and Indonesia are

the non-traditional commodities developed by this type of FDI.

Box 3: Gold Rush? Mining Sectors in Ghana and Peru Attract Investment Capital

As a result of radical changes in their macro-economic and mining sector policies, Ghanaand Peru are experiencing rapid growth in their mining sectors after a long period of stagnation.The experience of both countries demonstrates the importance of providing favorable businessenvironment with a minimum of risk and government intervention to domestic and foreign privateinvestors, even for countries with abundant natural resource potential.

Ghana, with a gold mining history dating from the 1800s, is a good example. In the early1960s the volume of Ghana's annual gold production was around 31 tons, but by 1983, productionhad declined to 8.6 tons. This decrease was mainly due to insufficient investment in exploration,development and technological improvement as a result of a poor business environment. Followingthe introduction of an economic recovery program in 1983 which was accompanied by a series ofmining sector reform measures, Ghana's official production of gold increased from 8.8 tons in 1984to nearly 50 tons in 1994. From 1990-1994, the export value of gold more than doubled fromUS$206 million in 1990 to US$570 million in 1994. Also, the introduction of The Small-Scale GoldMining Law of 1989, resulted in an increase in the purchases of gold from small-scale miners by agovernment agency from 0.3 tons in 1989 to I ton in 1993, in US dollar terms, $3.7 million and$12.6 million, respectively.

The reform program included overall economic reform with significant measures aimed atencouraging foreign direct investment, especially in the mining sector. The most important were: (i)establishment of the legal/rezulatorv framework: The government reformed the regulatoryframework in consultation with IDA and enacted new laws and regulations aimed at reducing risksfor investors and guaranteeing ownership rights to produce minerals; (ii) institutional reform: Thegovernment has restructured its mining sector institutions. The Ministry of Energy and Minerals(MEM) and the Minerals Commission (MC) were restructured to promote direct private investmentand facilitate foreign-funded mining activities in Ghana; and (iii) privatization: The governmentdivestited the three state-owned mines to three private-owned firms, and undertook public offering ofgovernment stock of the largest gold producer in the country.

20

Although private sector investors were attracted by the government's reforms to invest in theGhanaian gold sector, perceptions of political risk and lack of access to commercial sources of hard currencyloan financing have remained as a problem. This has been partially addressed by IFC which has played animportant role in helping tinance the rejuvenation and development of the sector. Since the mid-1980s it hasinvested or mobilized directly about US$400 million in the form of loans and equity for the Ghanaian goldsector. In particular it helped to increase the gold production of Ashanti Goldfields Limited AGL) to around31 tons annually with ius support of an investment program spread over 10 years, and to access internationalmarkets forward gold sales.

The key to the current success of mining sector growth in Ghana was the creation of efficient andeffective linkage between regulatory and institutional frameworks. The provision of transparent laws andeffective supportive agencies to enforce the laws and monitor mining activities within the legal frameworkhas reduced investors' risks. In addition, the establishment of a favorable macro economic environment andregime has ensured investors of minimum political intervention and maximum financial freedom. such asfavorable tax and foreign exchange retention.

In Peru, as in Ghana, the mining sector had been stagnant for a long time. Due to politicalinstability, serious econiomic crises and unfavorable export policies, it became unattractive to foreigninvestors in spite of its abundant and widely recognized mineral endowment. In 1991, the governmentinitiated a radical program of stabilization and structural reform. It enacted the Free Market MarketingDecree which aimed at economic and political stabilization, restructuring of the government, provision of afavorable legal and financial environment for foreign investors including foreign acquisition of domesticmining enterprises, and promotion of privatization. One of the main objectives was restoration of the miningsector through the promotion of new investment utilizing existing capacity. In this respect, privatization ofstate-owned mines was the most important measure in attracting investors, leading to a surge of foreigninvestment and related commitments for example, in 1994 the foreign acquisition of mining enterprises inPeru totaled US.714 million and the investment commitments totaled US$2.2 billion. In the gold sector,output has already climbed from 16.7 tons in 1991 to 42 tons in 1994.

Gold Production in Ghana

50

40

30

10

074 76 78 80 82 84 86 88 90 92 94

Years

Source: World Metal Statistics Yearbook: World Bureau of Metal Statistics

21

Enabling Environment to Increase Investment

A recent study bv Hausmann and Gavin (1995) argues the importance of a stable

macro-economy in enhancing investment. In this context, the ability of a commodity-

dependent country to stabilize its economy in the face of commodity price fluctuations

becomes critical. Commodity-dependent countries experience frequent but unpredictable

boom/bust price cycles. As discussed in a recent World Bank study (World Bank (1995))

the impact of these cycles has been considerably less in the successful commodity-

dependent countries than in the unsuccessful ones, not only because the former were more

diversified but also because they better stabilized their macroeconomies through

implementation of appropriate policies.

Evidence of the difference in macroeconomic policies implemented between strong

and lagging integrators can be seen from correlation between the degree of integration and

the budget deficit, and between the degree of integration and the volatility of the budget

deficit during the period 1984-93 (see Table 4). A disaggregation by speed of integration

of countries that were commodity-reliant at the start of the period (defined as those with

at least 50 percent of exports in primary commodities) shows that the strong integrators

ran much lower deficits; a median of 4.3 percent of GDP versus 7.1 percent for the

lagging integrators.

In addition to the need for macro-economic stabilization, an open market

environment, one that encourages private sector participation including that of foreign

firms, is also a key to increasing investment. This open environment should predominate

not only in the areas of trade and investment but also in the financial sector.

22

Table 4: Integration, Policy and Performance in Commodity-reliant Developing Countries

Commodity Commodity-Reliant(l)Non- Strong LaggingReliant(l) Integrators |Integrators

Number of Countries: 15 15 16

Macroeconomic Policy Variables

Budget Deficit as % of GDP -4.98 -4.29 -7.09Budget Deficit Volatility 2.60 2.65 5.82CPI Inflation 14.00 13.94 7.25CPI Volatility 0.53 0.57 1.82

Growth Performance

Per Capita Real GDP Growth 1.24 2.09 -1.80Per Capita Investment Growth -0.45 3.35 -7.20Note: (1) Commodity Reliance (defined as more than 50% of exports in 1981-83).Source: International Economic Department, World Bank

However, the commodity-dependent economy's heavy reliance on the commodity

sector as a major source of government revenue makes it a frequent object of government

intervention, which usually has negative effects on the development of that sector.

Common forms of government interventions include fixed producer prices, state-owned

enterprises dominant in marketing, exporting and processing, and protectionist measures

against foreign firms and products. These interventions, which usually are

counterproductive, are considerably more prevalent in unsuccessful commodity-dependent

countries than in successful ones.

23

III. Policies Promoting Viable Commodity Sectors

By reviewing various recent cases, this section aims to identify the concrete

government policies that contribute to creating and maintaining dynamic commodity

sectors in the successful commodity-dependent economies. Specific policies empirically

demonstrated as critical to sound commodity sector development are: (i) eliminating

market controls and dominant state-owned enterprises in the market; (ii) enticing foreign

capital and technology transfers; (iii) promoting research and extension; (iv) developing

good infrastructure in transportation and communication; and (v) establishing a legal

system hospitable to innovative financial instruments/systems.

Case studies in this section demonstrate that all of the above policies work best in

a complementary manner as a government policy package to create an environment in

which benefits from private and/or foreign firms' activities can be maximized. Such an

environment is also conducive to increasing investment and developing technology. In

other words, creating enabling conditions through sound policies and providing key

physical, financial and legal infrastructure to entice private sector investments and

activities into the commodity sector are first and foremost roles of the government of

commodity-dependent countries.

Eliminating Market Controls and Dominant State-Owned Enterprises in the Market

Governments of commodity dependent countries tend to intervene in their

commodity sectors ostensibly because of the volatile nature of commodity prices and of

the heavy reliance of government revenue on commodity sectors. Two commonly

observed manifestations of government intervention in commodity-dependent economies

are a dominant role of state-owned enterprises (SOEs) in the commodity market, often

having monopolistic status, and the implementation of market controls. A major problem

with the dominance of SOEs is their inefficient operating practices. A number of cases

show that government market controls usually have the effects of distorting market

24

signals which hinders healthy market responses and of lowering producer prices,

especially in the long-run. These interventions often impede long-term development and

transformation of the commodity sector, especially from traditional to non-traditional,

because they tend to enforce the status quo.

One of the underlying reasons for the inefficiency of SOEs is that the managers

frequently do not have sufficient decision making powers over their operations. This

often results in inefficient and inadequate responses by SOEs to market signals, such as

new trends in world commodity demand. Also, SOEs' inefficiency is evidenced in their

production and marketing costs, usually being much higher than those of private

enterprises. For example, a recent study (Varangis et al, forthcoming) shows that cocoa

marketing costs are two to three times as much in countries such as C6te d'Ivoire and

Ghana, where the marketing is controlled by SOEs, compared with countries with

liberalized markets such as Malaysia and Indonesia (see Figure 5).

The privatization or elimination of marketing boards, a typical form of SOEs, in

several African countries was an important element in the market liberalization which

revived many of their commodity subsectors. Most of the recent increase in mining

output in Africa came from private enterprises while at the same time SOE output

stagnated or even declined (World Bank (1992)). Oie of the main reasons for this

contrast is the access of private enterprise to the management and technical skills of

international mining companies and the ability of those companies to mobilize the

financing necessary for exploration and investment. In Chile, copper production is

expected to increase much more from private enterprises than from the state-owned

CODELCO due to their ability to attract FDI.

25

Figure 5: Marketing Costs as a Percent of the Selling Price

60 -

50 -

40-

30-

20-

10-

0 oci) coi coiC

Suc:~ Caclae fro 0at prvddbytesud fRf 93

CD ~~cc i 06 0 0 4~~) 2 2:m

.( ) co

Note: Data used from those of 1989Source: Calculated from data provided by the study of Ruf (1993)

Recent developments in Sri Lanka's state-owned tea estates illustrates the

importance of the elimination of state powers for effective privatization. In 1992, the Sri

Lankan Government restructured loss-making SOEs by consolidating 422 state-owned

tea, rubber and coconut enterprises into 22 joint-stock companies. The management of

these companies was contracted out to 22 private firms under a profit sharing plan that

divided the profit 25 percent and 75 percent between the management companies and the

SOEs. The main objective of this plan was to make the enterprises profitable by

increasing their efficiency and by attracting private capital for investment. As can be seen

from Table 5, productivity of these SOEs remained considerably lower than that of Sri

Lanka's private sector enterprises and of other countries. Thus far, the plan's objectives

have been frustrated and most of the SOEs continue to record large deficits. The

principal reason for this failure seems to have been an absence of the institutional

framework for transferring effective control to the private companies. The managing

companies were not allowed to acquire ownership in the ventures of to make strategic

management decisions. One result of this was a substantial labor wage increase over

time. Also the financial incentives given the managing companies were not sufficiently

attractive for them to make investment.

26

Table 5: Tea Productivity and Profitability in Selected Producing Countries in 1991

SriLanka SriLanka North India South India KenyaState Private

Yield (kg/ha) 1268 2442 2127 2300 2237Intake per plucker (kg/day) 13.52 24.59 26.22 25.24 48Labor per ha 3.21 2.7 2.67 2.5 2.2Cost of production ($/kg) 1.87 1.54 1.52 1.39 0.94Revenue ($/ha) 2574 4957 4318 4669 4338Gross profit ($/ha) 203 1196 1085 1472 2438

Source: World Bank

Another negative effect that government-controlled marketing and pricing systems

have on the commodity subsectors is that they are usually accompanied by rigidly fixed

producer prices, often determined on political considerations and without due account of

world prices. Some economists argue that the large deviation of domestic prices from

world prices is an important symptom of a closed economy, which causes those countries

lag in the integration process (see Slaughter (1995)). The governments' stated objective

of this rigid producer price system is to stabilize income of commodity producers.

However, in most cases, such policies not only distort market signals but also do not

necessarily stabilize producers' income. Furthermore, they often result in heavy implicit

taxation.

In many countries, before market liberalization, pricing and marketing in

commodity sectors were strictly controlled by the government. This was the case with

coffee, cotton, and cashews in Tanzania, coffee in Uganda, coffee and cocoa in Cameroon

and coffee in C6te d'Ivoire. In Tanzania, farmgate prices were set by the government and

domestic marketing was undertaken only by the Cooperative Unions. Often the

government set the farmgate prices too high causing serious financial difficulties to the

Cooperative Unions. In Uganda, domestic and export marketing were carried out only by

the Coffee Marketing Board. To a considerable degree, because of the inefficiency and

rent-seeking activities of the Board, coffee farmgate prices were kept very low. In

Cameroon and Cote d'Ivoire, a bareme system was in force, under which not only

farmgate prices but also marketing costs, which were undertaken by private traders, were

27

fixed by the government. This gave little incentive to private traders to compete and to

become efficient. Under this system, established traders were practically guaranteed

profits.

The market liberalization process that started a few years ago in Tanzania

drastically changed its marketing systems for export commodities. A large number of

private traders, including many foreign and foreign-affiliated ones, have become active in

purchasing and exporting Tanzanian cashews. As a result, farmgate prices of this

commodity more than doubled between 1988/89 and 1991/92 in real terms. Production

which fluctuated around 20,000 tons in the late 1980s increased to 47,600 tons in

1993/94, and export volume increased by six fold between 1990 and 1993. A similar

phenomena occurred in the coffee subsector where farmgate prices also increased sharply,

by about 40 percent in real terms between 1988/89 and 1992/93 when world prices were

declining. It is too early to tell what the impact of liberalization will be on the cotton

subsector but it is an encouraging sign that a foreign firm is interested in investing in

ginning facilities. This would have been impossible before the liberalization as all the

ginneries were owned by the Cooperative Unions.

Cameroon's liberalization from the 1994/95 season of its coffee and cocoa

markets also has had an important impact on the marketing system and the farmgate

prices of these commodities. While previously farmgate prices and marketing costs were

strictly controlled by the Government, the liberalization allowed traders to freely enter

into competition in the marketing of these commodities. The impact on the farmgate

prices was immediate: farmgate prices of cocoa are estimated to have risen by 60 percent.

In C6te d'Ivoire, liberalization of the coffee marketing system essentially eliminated the

bareme system but its impact on the subsectors is yet to be evaluated. In Uganda, the

share of producer price in export price increased from about 20 percent in the mid 1980s

to over 60 percent through the liberalization.

28

Enticing Foreign Capital and Technology Transfers

One of the main characteristics of most commodity-dependent countries is their

limited capacity to accumulate sufficient capital stocks to expand production, to advance

technologies and to strengthen research, production and marketing skills. In many of the

successful cases of foreign capital and technology transfers, private firms have played

dominant roles in attracting foreign capital and technology. Yet, as Jaffee (1993) points

out, the contribution of governments in establishing environment favorable for the

smooth transfer of foreign capital and technology and for the development of these

industries has been significant. These contributions range from analysis and

dissemination of market information to establishment of export channels through

government negotiations.

Prominent successful cases of rapid commodity production and export expansion

due mainly to transfer of foreign capital and/or technology at least at the initial stage are

given in Table 6, which covers most of the recent cases of such expansion by developing

countries. Examples not included in Table 6 are the production expansion of gold in

Ghana and Peru and diamonds in Botswana.

29

Table 6: Successful Cases of Foreign Capital and Technology Transfers

Commnodities Host countries Export value in 1993 Increase in exports(millions of US$) in real terms

(1980-1993)Tomatoes Mexico 395 1.4 foldVegetables China 58 1.5 fold

Kenya 16 0.9 foldGrapes Chile 327 6.8 foldCut Flowers Tanzania 0.4" 7 fold3'

Kenya 82/ 2.4 fold"Colombia 383 2.7 fold

Soybeans Brazil 946 1.6 foldArgentina 547 7.6 fold

Poultry Thailand 351 6.8 foldTuna fish (canned) Thailand 8 n/aFresh shrimp China 80 3.6 fold5'Frozen shrimp Indonesia 756 2.7 fold

Thailand 1035 7.5 foldNote: n/a = not available1/19912/19923/ 1980-19914/ 1980-19925/ 1984-1993Source: International Economics Department, World Bank.

Factors that contributed to the successful cases given in Table 6 are summarized

in Table 7. Governments' contributions in these cases were: (i) encouraging research and

development: tomatoes in Mexico, grapes in Chile, chicken meat in Thailand, shrimp in

China and Thailand, soybeans in Brazil and Argentina and cut flowers in Kenya; (ii)

disseminating market information: vegetables in Kenya (in cooperation with the

International Trade Center, a UN organization), grapes in Chile, chicken meat in Thailand

and shrimp in China; (iii) granting subsidies/favorable tax treatment: tomatoes in Mexico,

vegetables in Kenya, grapes in Chile, chicken meat in Thailand, shrimp in Thailand and

China, and soybeans in Brazil and Argentina; (iv) providing physical facilities and

developing transport infrastructure: vegetables in Kenya (collection stations and airport

cold storage), grapes in Chile (processing facilities), tuna in Thailand (port facilities and

cold storage), shrimp in Thailand (cold storage) and China (ponds, hatcheries, storage and

processing facilities), soybeans in Brazil (storage) and Argentina (grain elevators,

30

transport facilities), and cut flowers in Kenya (cold storage) and Tanzania (airport cold

storage, road rehabilitation); and (v) promoting export: grapes in Chile (trade fairs and

market access negotiations), chicken meat in Thailand (market access negotiations), tuna

in Thailand (market access negotiations), shrimp in Thailand (market access negotiations)

and China (trade fairs) and cut flowers in Tanzania (establishment of producers and

exporters association).

Table 7: Involvement of Government and Foreign Firms in Selected Commodity ExportDevelopment

Commodities R&D Training Phisical Technology Production Production Pr-ocessing ExportInfrastruc- Inputs Financing Marketing/ Promotionture Financing

Gov. F Gov. F Gov. F Gov. F Gov. F Gov. F Gov. F Gov. F

Tomatoes (Me3dco) X X X X X X XVegetables (Kenya) X X X X X XGrapes (Chile) X X X X X X X X x XCut Flowers (Colombia) X X X XCut Flowers (Tanzania) X X XCut Flowers (Kenya) X X X X XSoybeans (Brazil) X X X X X X XSoybeans (Argentina) X X XPoultry (Thailand) X X X X X X X X X XCanned Tuna (Thailand) X X X X XFresb Shrimp (China) X X X X X X X XFrozen Shrimp (Thailand) X X X X X X

Note: Gov: Government and F: FDISource: S.Jaffee (1993), and International Economics Department, World Bank.

Promoting Research and Extension

Investment in research and extension is indispensable to advance technology and

to collect information necessary to increase productivity of traditional cormnodities and to

develop non-traditional commodities. Rapid growth in the cocoa and palm oil exports of

Malaysia and Indonesia (see Box 4) and the potential for growth of coffee production in

Uganda are examples that underline the importance of research and extension in

commodities. The main reason Southeast Asian countries have been competitive in the

export of commodities in spite of rising labor costs is the sharp increase in productivity

and/or development of non-traditional commodities they have achieved through research,

extension, and/or importation of new technologies.

31

Box 4: Importance of Agricultural Research - Case of Malaysia's Palm Oil

The palm oil industry in Malaysia illustrates the importance of research and development tomaintain competitiveness. Yields in Malaysia have continued to increase over the years and in recentyears has doubled that of African producers. The underlying differences in yields provide a huge cost-of-production advantage to Malaysia. In turn, the current advantage in yields came from aggressivelyadapting and developing technological gains, initially through private estates, and then later, with theaggressive support of government. Consequently, Malaysia's market share in world production increasedfrom 7 percent to 51 percent during the last three decades while that of Africa declined from 75 percentto 14 percent during the same period (see Figures below).

In the 1970s, new planting materials suited for Malaysia's climate were developed from thetenera fruit form, a hybrid oil palm developed in Zaire in the 1940s. Calculations based on yields fromthe new planting materials convinced both the private sector and the government that palm oil would bemore profitable than rubber, one of the Malaysian key products during that time. While governmentrestrictions prevented an expansion of estate areas, private estates expanded rapidly into palm oilproduction, by replanting palm oil into rubber areas. At the same time, oil palm became the method offinancing settlement projects for smallholders arranged by the Federal Land Development Authority(FELDA). FELDA opened up large tracks of virgin forest and small holder production grew rapidly. By1988, estate area under oil palm totaled 908,900 hectares, and smallholders, mostly governmentsponsored, cultivated 905,800 hectares.

Several semi-public organizations contributed to the development of the Malaysian palm oilindustry. In 1977, The Palm Oil Registration and Licensing Authority (PORLA), composed of industryand government members, was established to be charged with regulating, licensing, and promoting palmoil. In 1979, The Palm Oil Research Institute of Malaysia (PORIM) was established to conduct researchand development in biology, chemistry, technology, nutrition, and economics.

Research undertaken by the private estates and more recently by PORIM has resulted in plantingmaterials and techniques well adapted to the climates of Malaysia and Indonesia. In 1982, oil extractionrates were boosted by a third by releasing a weevil that improved pollination.

Shares of Palm Oil Production

8% 10% 9% 14% 11%

i 7% < T | . | 1 24% Qlndonesia14%

23% M: . U Malaysia0 Africa

qor ~~~~0 Others

75% 54% 51%

Average 1961-1962 Average 1981-1982 Average 1992-1993Source: Food and Agriculture Organization (FAO)

32

In spite of its importance, research and extension in many commodity dependent

countries are in a poor state, as noted by Cleaver and Donovan (1995). Their study also

points out that in addition to input supply constraints and lack of incentives for farmers to

use improved technology, poor extension is the major issue in agricultural productivity in

Sub-Saharan Africa. Recent evaluations of T&V (Training and Visit) extension in Kenya

(Vindish and Evenson, (1993)) and Burkina Faso (Vindish et al, (1993)) show extremely

high economic rates of returns to extension, but the long-term productivity increases

through extension depend on the generation of suitable improved technologies.

The governments of commodity-dependent countries can be instrumental in

identifying the commodities in which they have comparative advantage. In the area of

research and extension activities, governments can take include identifying investment

potential for new export commodities, undertaking basic research, providing extension

services, and disseminating the research results. For instance, conducting geological

surveys and disseminating information on mining potential of a country with mineral

resources are functions that could be undertaken by the government to attract investment

in the mining sector.

Several non-traditional commodity subsectors were developed through the

government enhanced research and extension in isolation or in collaboration with private

firms. Such cases include tomatoes in Mexico, grapes in Chile, chicken meat in

Thailand, shrimp in China and Thailand, soybeans in Brazil and Argentina and cut

flowers in Kenya.

Another comprehensive and sophisticated example is that of Chile. Chile has

successfully developed a number of new export products, including salmon, flounder,

black berries and forest products, largely through research, development, production and

marketing by Fundacion Chile, an organization funded equally by the Chilean

government and the private sector for the specific purpose of developing non-traditional

export products. Once a new industry is developed, Fundacion sells it to the private

33

sector. Because of its success, several countries, such as Bolivia and Colombia, have

imitated this approach.

The case of Ugandan coffee attests to the importance of market liberalization and

of a policy environment favorable for active private participation if a country is to reap

benefits of research and extension. Hybrid high-yielding coffee varieties were developed

in Uganda several decades ago. However, these new varieties were not available to the

farmers, not only because of the social and political turmoil but also because excessive

government interventions in the subsector practically excluded private initiative. With

the liberalization of export markets, the private sector has started to play a major role in

building nurseries and selling seedlings of the high-yielding varieties to farmers. Because

the liberalization also had the effect of raising farmgate prices substantially, farmers'

reaction to adopting the new varieties has been enthusiastic.

Developing Good Infrastructure in Transport and Communication

World commodity markets are becoming increasingly competitive. Good

transport and communication systems are becoming critical factors in creating viable

commodity sectors. Since cost of developing these systems is significant, governments

should make efficient plans that include accurate identification of the priority area and of

the most appropriate system to maximize the gains.

Recent examination of the cocoa subsector of Indonesia (see Akiyama and Nishio

(1996)), shows that the availability of adequate transport facilities was one of the main

reasons for the rapid expansion of the smallholder cocoa subsector on the island of

Sulawesi, from 18,000 tons in 1984 to 201,000 tons in 1993. An examination of areas

where the rapid cocoa production occurred reveals that the availability of inexpensive

transportation system, i.e., ground and sea transport and port facilities, was one of the key

factors in determining where and how much cocoa would be grown. One of the critical

factors is whether or not roads can handle 10-ton trucks. Conversely, Indonesia's

Transmigration Policy under which the government attempted to encourage migration

34

from the crowded island of Java to other islands often failed because of inadequate

attention to the transport system.

Investment in the mining sectors of most African countries has been concentrated

in metals and minerals with high value-weight ratios such as diamonds and gold. This is

due mainly to inadequate transportation systems in these countries. Many of these

countries do not have comparative advantage in producing metals with lower value-

weight ratios because of high transport costs. Consequently, rich deposits of base metals

in these countries remain unexploited. Development of adequate transportation systems

in African countries with rich deposits of base metals might entice new mining activities

which otherwise would remain ignored.

The importance of communication is evident in the case of horticulture. Many of

the exported horticultural products are perishable and the market situations of these

commodities in consuming countries change dynamically. Consequently, exporters of

horticultural products need to know the latest developments in their markets, which

require well-functioning and low-cost communication systems. The rapid growth of

horticulture exports (see Box 2) in Chile, Kenya, and Colombia would not have been

possible in the absence of these elements.

Establishment of Legal System for the Use of Innovative Financial Instruments and

System

One major obstacle to the development of commodity sectors in the commodity-

dependent developing countries is the weakness of the financial system. King and Levine

(1993) recently studied the empirical link between a range of indicators of financial

development and economic growth, and concluded that a sound financial system is

important for economic development. Financial institutions contribute the development

of sound commodity sectors in various ways including providing a mechanism to

facilitate the financial transactions of foreign and domestic firms and offering investment

credits to farmers and traders.

35

In spite of their importance, financial institutions in many commodity-dependent

countries are weak and many of them are insolvent. Consequently, rural financing has

been limited in these countries because it is not cost effective and because the credit

recovery rate has been low in the rural sector.

Governments of commodity-dependent countries are aware of the importance of

such institutions but most of them have had considerable difficulty in strengthening or

restructuring them. However, recent developments in a number of successful commodity

exporting countries suggest that there are two innovative financial instruments/system

that can contribute significantly to the commodity sector--risk management instruments

and the warehouse receipt system (see Box 5). The former is an almost indispensable

instruments for commodity traders to eliminate the price risks inherent in commodity

trading, and the latter would greatly strengthen inventory and export financing. For these

instruments/system to develop, governments need to strengthen the legal structure,

especially in the areas of brokerage firms, taxes, collateral, insurance and the overseas

transfer of foreign exchange. Such government actions would create an environment that

encourages the private sector to implement these instruments/system. Under such an

environment foreign firms can provide the services, implying that implementation of the

innovative instruments/system is possible even in countries without sound domestic

financial institutions.

36

Box 5: Warehouse Receipt System--Potentially Powerful Trade and Inventory Financial Instrument

Warehouse-receipts are widely used in industrialized countries as secure collateral to obtainfinancing for commodities. Their use has been limited in developing countries mainly due to lack ofappropriate legal and institutional environment. The potential benefit of this system in these countries,however, is considerable, especially in countries where financial institutions are weak.

The working of the system can be explained as follows. From his own initial working capital, alocal buyer makes crop purchases. He then places his crop in a bonded warehouse. The warehouseregisters the delivery and issues a receipt (also called a warrant or certificate) for the crop. Generally thereis a formal registration of the receipt. (In this case, the receipt or warrant is perfected.) The receipt canthen be used to obtain credit from local banks. In practice, the warehouse itself frequently operates as abank, entering into repurchase agreements with the local buyers. That is, the warehouse "buys" thecommodity from the local buyer and gives him an option to "repurchase" the commodity in the near future(say in 60 days or less) at a slightly lower price. The spread between the two prices is equivalent tointerest on a standard loan. When the receipts are standardized, banks can also create a secondary marketwith other financial institutions. The warehouse has now certified the quantity and quality of the crop.The financial institution (which may be the warehouse itself) can then also hedge the price of thecommodity through option trading, futures contracts, etc.

The combination of the warehouse receipt and price hedge makes the collateral completely secure.The warehouse is bonded and insured, and guarantees the physical collateral. The price-hedge guaranteesthe collateral's value. Reduced risk results in reduced charges by institutions that lend against thiscollateral. In addition, since anyone with the commodity can deliver it to the warehouse, entry barriers areextremely low.

For smallholder crops in developing countries, this system has immediate and obvious benefits,lowering what is frequently perceived as high counter-party performance risk. Lower risk, lower financecosts, and increased competition for local commodities decreases marketing margins and increases theshare of export price received by fanners.

Warehouse receipt systems are privately financed and executed; however, the government mustinitially establish the proper regulatory and legal environment. In sectors that have been dominatedhistorically by parastatals and government interventions, this legal infrastructure is lacking. Such appearsto be the case for Tanzania, Uganda, Cameroon, which are among several countries undergoing marketliberalization.

There are five areas which may require specific legislation:Clear rules on rights to collateral: Warrant holders must be confident that they have clear and completetitle to the stored commodity without resorting to time-consuming legal battles.

Standardization of receipts: The receipts or warrants should be standardized. That way, receipts fromsay coffee stored in one of several warehouse could be traded easily in secondary markets.

Monitoring of warehousing system: Warehouses issuing warrants must be bonded, must meet safety andsecurity standards, and must conform to strict according guidelines. A regulatory agency should bechanged with making random inspections.

Banking rules and regulations: Changes to banking rules and regulations may be required to handlewarrants, especiaUy in a secondary market.

Risk management environment: Dealers in warehouse receipts will want to engage, directly orindirectly, in existing futures and options markets overseas to secure the value of the collateral--the storedcommodity. Specific rules on money transfers, changes to the tax code to value options and futures, andconsumer-oriented disclosure rules may need to be written or adjusted.

37

The introduction of market-based risk management instruments such as futures,

options and swaps facilitates the management of risks arising from commodity price

volatility and strengthens the export financing of commodities. Beneficial effects of these

instruments include: (i) reducing short-term price uncertainty and increasing short-term

price stability; (ii) increasing the predictability of commodity related revenues to the

government and/or to the private firms; (iii) mitigating short-term adverse effects of price

volatility; (iv) adding flexibility in the timing of selling and buying commodities; (v)

externalizing commodity price risks by shifting these risks to international markets; (vi)

reducing the price risk associated with financing commodity projects; and (vii) obtaining

project financing at better terms (e.g., Ashanti Gold Mines in Ghana, Mexicana de Cobre

in Mexico, and Sonatrach in Algeria).

The importance of risk management to the government and the economy was

evident in the case of Mexico after the Gulf war. The Mexican government used a

complex mix of oil futures, options and swaps to hedge six months of its oil exports.

This ensured the government a fixed and predictable revenue, allowing policy-makers

time for adjustment when prices did collapse.

Private traders, too, can benefit from hedging. Traders who have committed to

deliver a commodity, which they do not yet own, at some fixed price stand to incur big

losses if the price rises sharply and unexpectedly. Similarly, traders who contract to buy a

commodity from farmers at a fixed price in the future would suffer if the price fell. They

would receive a lower price when selling the commodity, and that price might not cover

the higher price they paid to farmers. A number of Indonesian coffee exporters are said to

have gone bankrupt or suffered mammoth losses in the mid-1980s (and in this past year)

because they did not take appropriate hedging actions. Ugandan coffee traders face

sirnilar problems.

Another example of the successful use of innovative financing with a risk

management instrument is found in a large-scale investment in the Ashanti Gold Mines of

38

Ghana. With the technical help of IFC, Ghana was able to arrange for financing of its

largest gold mines through the forward sales of gold (see Box 3). This arrangement was

possible because Ghana's liberalized financial sector and changed regulations made it

more attractive to investors.

As discussed in Box 5, the warehouse receipt system, already widely used in

industrialized countries, could significantly strengthen export financing for commodities

in developing countries. The system essentially consists of warrants issued by certified

warehouses with commodities as collateral. These warrants can then be discounted by

financial institutions increasing the liquidity of commodity exporters who otherwise

would need to wait for the completion of their export transactions to receive money. The

system has already been implemented in several developing countries, including Brazil,

Mexico, and Indonesia, and is under consideration in Uganda, Poland and Croatia.

39

IV. Conclusion

Because of its general association with low export growth and low income,

commodity dependence has been considered a culprit in economic development. This

notion regained prominence when commodity prices experienced a drastic decline in the

1980s. In the present paper, this commodity-dependence pessimism is examined both

theoretically and empirically. The paper demonstrates that problems often associated

with commodity-dependence do not arise because of commodity-dependence per-se and

that they can be alleviated through appropriate policies. The paper also infer that

dependence is a symptom but not the cause of underdevelopment. In other words,

countries with low export and income growth tend to be commodity dependent mainly for

historical reasons or their inability to develop industrial bases, but countries can be both

commodity dependent and have high export and income growth. This conclusion has

important ramifications for commodity-dependent developing countries because if the

pessimism is, in fact, ill-founded, it would be a mistake for these countries to adopt

policies based on the pessimism because they could actually destroy an engine of growth.

An examination of the components of successful commodity sectors in various

countries strongly suggests that it is the initiatives and innovative actions of the private

sector that make these commodity sectors dynamic and vibrant. Such successful cases are

found in the coffee sector in Uganda, the gold mines in Ghana, and the cut-flower

industry in Colombia. Transfers of foreign capital and technology that have played

important roles in developing new commodity and processing industries in a number of

countries are best achieved when the private sector takes the initiative.

This paper, however, finds that there are important roles for governments to play.

These include eliminating price controls and state monopolies, promoting research and

development, developing infrastructure in transportation and communication, enticing

foreign capital and technology transfers, and establishing a legal system for the use of

innovative financial instruments.

40

A review of unsuccessful commodity dependent countries reveals that most of

them retain traditional production, marketing, and export systems, often carried over from

the colonial period. In these countries, government interventions are often excessive.

Two prevalent interventions are the dominant role of SOEs and the manipulation of

commodity markets, especially prices. These usually result in introducing inefficiencies

into the production and marketing systems and in distorting market signals, which in turn

hinder healthy development and transformation of the commodity sectors.

The world commodity markets are becoming increasingly competitive. However,

recent developments suggest that there are a number of factors emerging that could

provide new opportunities for commodity exporting countries including a general global

trend toward trade liberalization, sharp increases in capital and technology transfers, and

high income growth in many developing countries, notably China and India. Income

elasticity for commodity demand is likely to be high in these countries. In such an

environment, countries having key components to become successful commodity

exporters as discussed in this paper can seize these opportunities; but for countries that

cannot or do not adapt to new demands and opportunities, commodity-dependence

pessimism will become a self-fulfilling prophecy.

41

APPENDIX

GEP96 Country Classification by Speed of Integration

High Income Fast/ Moderate Weak Slow/Strong Lagging

AUSTRALIA ARGENTINA BANGLADESH BRAZIL ALGERIA

AUSTRIA CHILE BOLIVIA BURUNDI ANGOLA

BELG-LUX COSTA RICA BURKINA FASO C.A.R. BENIN

CANADA CZECH, FMR DOM. REP CHAD BOTSWANA

DENMARK GHANA EL SALV. CHINA BULGARIA

FINLAND HUNGARY GREECE COLOMBIA CAMEROON

FRANCE INDONESIA GUATEMALA ECUADOR CONGO

GERMANY ISRAEL HONDURAS EGYPT COTE D'IV.

HONG KONG JAMAICA INDIA ETHIOPIA GABON

IRELAND KOREA IRAN GUINEA IRAQ

ITALY MALAYSIA KENYA HAITI LESOTHO

JAPAN MAURITIUS MADAGASCAR JORDAN LIBERIA

KUWAIT MEXICO MALI MALAWI NIGER

NETHERLANDS MOROCCO ROMANIA MAURITANIA NIGERIA

NEW ZEALAND NEPAL RWANDA MYANMAR OMAN

NORWAY PAKISTAN SENEGAL NICARAGUA PANAMA

SINGAPORE PHILIPPINES SYRIA P.N.G. PERU

SPAIN POLAND TANZANIA PARAGUAY S AFRICA

SWEDEN PORTUGAL TUNISIA SUDAN SAUDI ARABIA

SWITZERLAND SRI LANKA U.A.E TOGO SIERRA LEONE

UNITED KINGDOM TAIWAN UGANDA TRIN & TOB SOMALIA

UNITED STATES THAILAND ZAIRE URUGUAY SOVIET UNION

TURKEY ZIMBABWE VENEZUELA YEMEN

ZAMBIA

Source: Global Economic Prospects and the Developing Countries 1996 (forthcoming), Chapter 4,World Bank.

42

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I

I

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