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: nyenus23@gmail.com.2 Lecturer of Economics, Adigrat University, Ethiopia. Email: hayelomyrgaw@gmail.com.

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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

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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)

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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

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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

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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.

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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.

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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).

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Figure 1: Response of endogenous variables to one standard deviation commodity price shock

with 95 per cent conditional confidence bands

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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.

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