II. The Natural Resource Curse: Literature Overview and Country Examples1
1. The expectation that favorable natural resource endowments would lead to rapid economic growth and higher living standards has generally been disappointed. Empirical research suggests that countries with large natural resource wealth tend to lag behind comparable countries in terms of real GDP growth.2 The findings related to the so-called “curse of natural resources” (Sachs and Warner 2001) or, in slightly different terms, the “paradox of plenty”(Karl 1999;) seem to be remarkably robust and can not be explained easily by trends in commodity prices, geographical or climatic variables, or other unobserved growth impediments. This observation applies to oil producing states in the Persian Gulf, Nigeria, Mexico, and Venezuela as well as to primary commodity producers like Cote D’Ivoire (cocoa), and mineral producers such as Zambia (copper) and Ghana (gold).
2. Many economies have become progressively more reliant on natural resources over time. Oil and gas production in Nigeria and Venezuela has risen to account for 95 percent and 75 percent of export earnings, respectively, and 75 percent and 46 percent of government revenue. In the case of Nigeria, this is partially explained by the significant deterioration of export-oriented agriculture since oil became an important economic factor in the early 1970s (Bevan et al. 1999).
3. Nonetheless, a few countries have managed to avoid the ‘resource curse.’ In Indonesia, oil and gas exports rose quickly in the 1970s, and reached 50 percent of exports in the early 1980s. The economy grew by an average of 4 percent per year during 1965-90, undergoing significant diversification (Bevan et al.1999). In Botswana, the diamond sector has grown rapidly since the 1970s with diamond exports now accounting for around 40 percent of GDP. The country achieved double-digit growth in the 1970s and 1980s, a development not exclusively explained by a “mineral enclave” (Acemoglu et al. 2003). Malaysia, which is rich in a number of primary commodities, also grew by 4 percent per year on average during 1965-90. Australia has also succeeded in becoming one of the wealthiest countries in the world, based on the exploitation of its natural resources. The country has experienced a series of resource booms, which have changed its productive base radically.3
4. Explanations of the ‘resource curse’ have focused on a combination of four different factors: (i) the loss of competitiveness in the non-resource traded sector (“Dutch Disease”); (ii) the relatively high volatility of world commodity prices, with particularly damaging effects on fiscal revenues; (iii) the interaction between specialization in non-tradables and financial market imperfections; and (iv) the negative effect of ‘rent-seeking’ behavior on institutions, governance, and political processes, which may be exacerbated by the dominance of extractive industries.4
A. Dutch Disease
5. The flow of additional foreign exchange arising from the exploitation of natural resources may cause an appreciation of the real exchange rate. The subsequent loss of competitiveness in the non-resource tradable goods sector may be a problem if it inhibits growth of other key sectors such as the manufacturing sector, which is widely believed to be an engine of early development and a potential source of mass employment and growth. Based on empirical analysis, Sachs and Warner (2001) suggest that “one explanation of the resource curse is that resource abundance tended to render the export sectors uncompetitive and that as a consequence resource-abundant countries never successfully pursued export-led growth.”
6. However, movements in relative prices following the discovery of natural resources do not inevitably lead to adverse consequences for the economy. If the resource flow generated by exploiting the natural resource is relatively small and/or there are underemployed factors of production that can be utilized with little cost, an expansion in aggregate demand will not necessarily lead to an exchange rate appreciation. Several empirical studies have questioned the links between resource exploitation, relative prices, and non-resource sector exports.5 A rise in the relative price of non-resource tradables may be mitigated by an accumulation of foreign reserves or through outward foreign investment (i.e. increased savings). In the presence of excess capacity, the domestic economy can also expand, using foreign exchange inflows to stimulate domestic production. Expansion from internal sources may be consumption-led—i.e. resulting in an immediate increase in real living standards—or investment-led and, thereby, designed to raise future productive capacity. A consumption-led approach poses risks to a slow-growing country with structural weaknesses in its balance of payments in the case of temporary foreign exchange inflows (Thirlwall and Gibson 1992). In contrast, an investment-led approach could counter any loss in competitiveness in the non-resource tradable goods sector if productivity would rise sufficiently to offset the appreciation of the real exchange rate. However, the latter approach depends crucially on the effective utilization of capital investment.6
7. Revenue from natural resources may be more volatile than revenue from a broad base of export goods. International oil prices have shown an even higher degree of volatility than the prices of other commodities, and this may be because of the specific structure of the market, important geo-political influences, and the high fixed costs involved in exploration and production (Engel and Valdés 2000).
8. Volatile swings in resource revenues often lead to procyclical expenditure that may increase uncertainty and reduce investment and growth(Barnett and Ossowski 2002). Frequent unpredictable adjustments to fiscal expenditure are costly and undermine the ability of policymakers to implement multi-year spending programs. Figure 1 highlights the mixed response of public expenditure to oil price fluctuations in selected countries. Indonesia has been notably more successful in smoothing public expenditure relative to GDP and oil price fluctuations than either Venezuela or Nigeria (Bartsch et al. 2004). Nonetheless, occasionally, significant cuts of absolute spending levels had to be made in Indonesia when oil revenue and GDP declined, for example in the early 1980s.
Figure 1:Public Expenditure and the Oil Price in Selected Oil-Producing Countries
Source: Bartsch et al. (2004).
9. Governments sometimes also fail to appropriately modify their spending patterns to compensate for fluctuations in resource revenues, increasing the likelihood of large, costly adjustments. Spending programs are often launched during periods of high resource prices or on the basis of expected future earnings, without due regard for the risks or costs associated with having to reverse them. If these spending programs become entrenched and prices fall unexpectedly, or if future revenues do not materialize, governments may borrow to maintain investments or social subsidies, often at a high cost and without prudent regard for sustainability.7 In Mexico, following the post-1979 oil-price hike, the government used oil revenue to finance a spending spree and as collateral for rising foreign debt (Easterly 2001). Mexico’s budget deficit reached 15 percent of GDP in 1982 as oil prices began to decline. The subsequent loss of confidence precipitated a sharp devaluation of the local currency, fiscal retrenchment, and the debt crisis of the mid-1980s. Nigeria has also been prone to costly periods of both extreme procyclical spending and unsustainable debt accumulation as it tried to maintain spending patterns fed by oil price booms (Bartsch et al. 2004).
10. Resource windfalls may undermine the political forces that could promote fiscal restraint and balanced growth-oriented policies. For example, in many developing countries the agricultural sector is the dominant employer; a government that identifies its political interest in maintaining or promoting the competitiveness of the agricultural sector may implement policies aimed at offsetting any negative impact from the flow of resources to the natural resource sector. Eifert et al. (2003) contrast Nigeria, which has a weak set of agricultural elites and a dismal growth record, with Indonesia, where the political strength of rural agricultural elites, particularly post-1966, may have acted as “effective agent of restraint through the first oil windfall.” This helped to guide Indonesian policy towards the promotion of macroeconomic stability, agricultural competitiveness, and investment, rather than the procyclical policies of many natural resource producers. In countries where the political system is not aligned around any productive sector, windfall gains may be used to support consumption, often through the public sector, rather than investment in support of long-term growth. A recent survey of the Cooperation Council of the Arab States of the Gulf (GCC)8 concluded that “high oil revenues financed excessive government expenditures [that] lowered growth” (IMF 2003b). Part of the explanation for the low level of returns from government expenditure in the GCC could be the high level of public consumption (Box 1).
Box 1.The High Cost of Government Consumption in the Persian Gulf
The oil-producing countries of the Persian Gulf amassed substantial financial reserves in the 1970s. However, the prolonged downturn in oil prices in the 1980s led to a rapid accumulation of public debt, in many countries at unsustainable rates. For example, Saudi Arabia’s domestic national debt increased from zero in 1987 to $62.4 billion in 1992, equivalent to about 70 percent of GDP and 200 percent of exports. The deficits were largely the result of the fuel, water, and electricity subsidies that had become entrenched and had grown to a total of $14 billion in fiscal year 1992 (Askari et al. 1997).
C. Inefficient Specialization
11. Inefficient specialization of production in combination with weak financial markets may lead to higher volatility in relative prices(Hausmann and Rigobon 2002).9 As suggested above, countries that are highly specialized and heavily reliant on volatile resource revenues will tend to experience larger relative price fluctuations, particularly with regard to the exchange rate, than more diversified and therefore balanced economies. This is particularly true in economies dominated by a capital intensive industry, such as oil, where capital investment is substantial and largely irreversible. Where the increase in the level of volatility interacts with imperfect financial markets—which may be relatively sticky and risk averse with high bankruptcy costs—risk premiums and thus interest rates will also tend to rise. Higher domestic interest rates will tend to undermine the non-resource tradable sector and lead to further specialization. Some countries, such as the members of the GCC, may be naturally specialized as a result of relatively large resource endowments, while others, such as Venezuela and Nigeria, may become overly specialized through their inability to develop a diversified tradable sector, which will be hampered by both the volatility stemming from fluctuations in international oil prices and higher domestic interest rates. According to Hausmann and Rigobon (2002) “inefficient specialization is the product of a combination of factors: the level of government spending, the volatility of the spending, the commercial-risk-free interest rate, and the magnitude of financial inefficiencies.”
12. Competition for resource rents may undermine governance and institutions, and crowd out innovation. Recent research has stressed the causal link between the quality of institutions—such as the rule of law, property rights, lack of corruption, and an appropriately sized government—and economic growth.10 However, the windfall revenues accruing from natural resources, particularly those arising from capital intensive industries, have often been associated with higher levels of corruption, weak institutions, and poor policies (Easterly 2001; and Leite and Weidman 1999). The vast common pool of resources accruing directly to the state may encourage misappropriation by interest groups and may undermine governments’ commitment to transparency or accountability. Rent-seeking behavior has also been found to distort the allocation of resources (Karl 1999;Box 2).
Box 2.Earmarking in Ecuador
Earmarking of revenue for expenditure items in the budget reduces the flexibility of the budget to respond to changes in the macroeconomic environment and may skew allocations towards lower priority areas. The struggle by entrenched interest groups to capture the resource rent in Ecuador has been associated with the rise in earmarking within the budget. In 1989, a high proportion of oil revenues was earmarked for the military (14.5 percent), the public wage bill (67.9 percent), and rural roads (a notable source of political patronage). In 1999, 65 percent of total tax revenues (including all oil revenues) were earmarked for specific programs or for subnational transfers (Eifert et al. 2003).
13. A large number of studies suggest a potentially negative impact of resource wealth on democracy, institution building, and transparency.11 Natural resource wealth, and in particular oil wealth, has been found to affect negatively the establishment of democratic institutions through a number of different channels (Ross 2001):
- A “rentier effect,” implying that governments use oil revenue to reduce social pressures that would otherwise result in demands for greater accountability. This effect is found to be composed of:
- (i)a “taxation effect,” according to which governments, which derive a large share of their revenue from resource extraction, are likely to maintain low taxation of the non-oil economy, reducing demand from the general public for accountability or representation in government (Isham et al. 2003);12
- (ii)an “expenditure effect,” as large public expenditure programs may increase government spending on patronage, reducing the latent demand for participation in democratic processes by “fiscal pacification”;13 and
- (iii)a “group-formation effect,” implying that governments may use revenue from resource extraction to prevent the establishment of independent social groups, which demand political presentation and rights.14
- A “modernization effect,” as the concentration of a small workforce with sophisticated technical skills in an offshore-type sector of the economy could delay occupational specialization and urbanization, thereby reducing pressures for the development of democratic institutions.15
- A “repression effect,” since governments that fund themselves through oil revenues have the capacity to build up excessive internal security, which allows them to block, at least temporarily, the population’s democratic aspirations.
14. The quality of institutions was found to determine the extent to which natural resources can be misappropriated, implying that countries with weak institutions are more prone to suffer a resource curse(Ross 2001). The importance of strong institutions for preventing corruption and its negative effects on growth has been emphasized by Leite and Weidmann (1999). The authors find this to be particularly important in developing countries with a potentially larger relative macroeconomic impact of resource discoveries and weak institutions. Institutional weakness was also found to pose risks to oil funds. The weaker the institutions of the state, the more likely it becomes that the public sector will be ‘captured’ by powerful interest groups (Easterly 2001). This in turn may distort the allocation of resources and encourage entrepreneurs to switch from productive activities in order to engage in unproductive rent seeking. The public sector may try to expand to meet the demands of interest groups and use earmarking or other devices to entrench benefits to particular groups. In extreme cases, resource rich countries have experienced prolonged periods of conflict, which have been exacerbated by issues surrounding the control and exploitation of the resources; these include: Angola, Liberia, and Sierra Leone.
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