A newly released IMF working paper investigates the impact of commodity price shocks on financial sector fragility.
Using a large sample of 71 commodity exporters among emerging and developing economies, it shows that negative shocks to commodity prices tend to weaken the financial sector, with larger shocks having more pronounced impacts. More specifically, negative commodity price shocks are associated with higher non-performing loans, bank costs and banking crises, while they reduce bank profits, liquidity, and provisions to nonperforming loans. These adverse effects tend to occur in countries with poor quality of governance, weak fiscal space, as well as those that do not have a sovereign wealth fund, do not implement macro-prudential policies and do not have a diversified export base.
The recent decline in commodity prices, especially for oil, has revived once again interest in their economic impact. Most commodities prices have declined by about 50 percent between mid-2014 and mid-2015, leading to significant losses in export earnings for commodity exporters. While commodity markets may be undergoing a transition to an era of low prices, such a sharp decline is not unprecedented.
Adverse commodity price shocks can also contribute to financial fragility through various channels. First, a decline in commodity prices in commodity-dependent countries results in reduced export income, which could adversely impact economic activity and agents’ (including governments) ability to meet their debt obligations, thereby potentially weakening banks’ balance sheets. Second, a surge in bank withdrawals following a drop in commodity prices may significantly reduce banks’ liquidity and potentially lead to a liquidity mismatch.
If large enough, commodity price shocks can also adversely affect bank balance sheets by weighing on international reserves and increasing the risk of currency mismatches. Third, a decline in commodity prices can reduce commodity exporters’ fiscal performance (by lowering revenue), which in turn may push government to adjust their budgets to accommodate revenue shortfalls. Often this can happen in a disorderly manner through the accumulation of payment arrears to suppliers and contractors, who in turn are unable to adequately service their bank loans.
Macro-prudential policies are gaining attention internationally as a useful tool to address system-wide risks in the financial sector. Macro-prudential policies act as an important factor for the stability of the financial sector. Macro-prudential instruments cover policies related to borrowers, loans, banks’ assets or liabilities, foreign currency credit, reserve requirements and policies that encourage counter-cyclical buffers (capital, dynamic provisioning and profits distribution restrictions). They may act as a tool to monitor the financial sector, therefore reducing the risk-taking and allowing the government to intervene on time.
The results show that negative commodity price shocks increase NPLs and bank costs, and decrease bank profits only in countries without macro-prudential policies. In contrast, countries with macro-prudential instruments are better able to cope with the detrimental impacts of adverse commodity price shocks. The implementation of macroprudential policy does not matter when it comes to provisions to NPLs as commodity price slumps lower provisions to NPLs in countries with or without macro-prudential policy.
Adverse commodity price shocks tend to lead to financial problems in non-diversified economies. The results also highlight that the detrimental effects of commodity price shocks are more common in countries with a low diversification of their export base. A lack of diversification may increase exposure to adverse external shocks and vulnerability to macroeconomic instability. While a diversified export base may allow countries to better handle declines in commodity related revenues with alternative sources.
In terms of policy implications, the findings underscore the necessity of adopting policies to increase the resilience of resource rich-countries. First, developing countries should promote sound economic policies and good governance that will ensure the effective use of natural resource windfalls and build fiscal buffers, including through sovereign wealth funds or similar arrangement. The presence of a sovereign wealth fund can effectively mitigate the impact of commodity price shocks and stabilize the economy. More generally, sound fiscal policy, characterized by low debt levels is an important buffer against exogenous shocks. Second, countries should implement macro-prudential policies in order to limit or mitigate systemic risk. Finally, countries should diversify their production and exports base in order to have more alternative sources of revenues allowing them to deal with the volatility of commodity exports related revenues.
Note: IMF Working Papers describe research in progress by the authors and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
