Beyond the curse: Policies to harness the power of natural resources

Rabah Arezki, Thorvaldur Gylfason, Amadou Sy 08 July 2012

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There is a broad consensus in academic and policy circles that the presence of natural resources poses a number of potential challenges in resource-rich countries, such as:

  • A loss of competitiveness in potentially dynamic, non-natural resource sectors leading to a narrowing of the production base,
  • Excessive government reliance on revenues derived from commodities and export earnings,
  • Too much macroeconomic and financial volatility; and
  • Rent-seeking behaviour that can undermine governance and exacerbate the difficulty of building robust, growth-enabling institutions (see for example Cabrales and Hauk 2011 and Caselli and Tesei 2011).

Our recent edited book (Arezki, Gylfason and Sy 2012) assembles contributions from several authors discussing the fiscal, monetary and exchange rate policy options confronting resource-rich countries, savings policies, suitable institutional arrangements to safeguard the economy against volatility, economic as well as political diversification, and institution building.

Fiscal policy

Government revenues in resource-rich countries are highly dependent on the prices of the commodities they export. Those prices are both highly volatile and hard to predict. In the short run, governments in resource-rich countries need to promote macroeconomic stability by decoupling current spending from volatile government revenues. In the long run, those governments need to establish medium-term spending plans to ensure intergenerational equity. Sustainable management of revenues derived from the exploitation of exhaustible natural resources can be achieved either through the accumulation of savings in sovereign wealth funds or through public investment in future growth outside the natural-resource sector (Das et al. 2009).

Fiscal institutions have proved helpful in achieving such decoupling between spending programs and revenues. For example, Chile has successfully implemented a fiscal rule that targets a structural budget balance set by an independent panel of experts. Countries with weaker institutional environments cannot, however, establish institutional arrangements capable of credibly committing to counter-cyclical or at least non-cyclical fiscal policies. In this context alternative policies could be explored, such as the use of financial instruments to hedge against the volatility in government oil revenues as has been done in Mexico. Norway has vested the management of its oil wealth in its independent central bank rather than in its ministry of finance for the explicit purpose of increasing the distance between the management of the oil fund and the political process (Gylfason 2008).

The decision to set up sovereign wealth funds in resource-rich developing countries needs to be guided by domestic conditions. While countries with high capital-to-labour ratios, such as Norway, have successfully set aside large pools of savings in dedicated sovereign funds aimed at guaranteeing intergenerational equity, many resource-rich countries in Africa have an urgent need to focus on investing in public goods to diversify their economies away from the natural-resource sector and to create the jobs that Africa needs so badly. Historically, Norway has focused its fiscal policies on the provision of public goods. Therefore, Norway can afford to be patient. Understandably, many developing resource-rich countries are in more of a hurry. Even so, the Norwegian model is far from being irrelevant to them. In the short run, their limited absorptive capacity may call for some savings to be put aside, possibly in sovereign wealth funds.

Strict standards, Norwegian style

From the outset, Norway set itself strict standards for natural-resource management, reflected in the Norwegian parliament’s adoption in 1972 of the so-called Ten Oil Commandments. The commandments include a commitment to (i) national supervision and control of all operations on the Norwegian Continental Shelf; (ii) the development of new industries on the basis of petroleum; (iii) respect for existing industrial activities and the protection of nature and the environment; (iv) a ban against flaring of exploitable gas (except during brief periods of testing); and (v) state involvement at all appropriate levels, contributing to a coordination of Norwegian interests in Norway’s petroleum industry. The commandments underpin the transparent ways in which Norway’s oil wealth has been allocated to its oil fund, now called a pension fund.

Monetary policy and exchange rates

Resource-rich countries frequently face large and volatile capital flows which complicate the conduct of monetary and exchange rate policy. Chile’s floating exchange rate coupled with an inflation-targeting regime has in recent years proved remarkably successful in sheltering the economy from external shocks. Many African countries, however, are fearful of embarking on a fully-flexible exchange rate regime. Therefore, a more gradualist path to exchange rate flexibility with inflation targeting will probably be pursued in many countries, with all of the transitional difficulties that this will entail. The experience of Ghana, which adopted inflation targeting with limited exchange rate flexibility since 2002-03, is an interesting example of a gradualist approach.

Yet another challenge is the Dutch Disease – that is, the tendency for natural resource booms to result in overvalued currencies that depress non-resource exports of goods and services, import-competing local industries and long-run economic growth but also tend to jack up interest rates and short-run capital inflows, thus creating macroeconomic and financial volatility. An important question here is how to stabilise exchange rates and sterilise current-account inflows in times of high commodity prices as well as capital inflows that are correlated with resource windfalls. Because equilibrium domestic interest rates are almost always above those in advanced countries, the costs of sterilisation can be significant and can create tensions between the fiscal authorities and the central bank. As is clear from the case of Botswana, however, insofar as periods of high commodity prices are also periods of large government surpluses held at the central bank, a properly managed counter-cyclical fiscal policy will provide a degree of automatic sterilisation.

Economic diversification

Experiences with industrial policy around the world suggest that it is not straightforward to design an appropriate incentive structure that would help lay the ground for economic diversification in resource-rich countries. Old-style industrial policies where government is directly involved in the production process need to be avoided. Indeed, those policies have in many cases been captured by local elites, opening the door to corruption and undermining the broader institutional framework. New industrial policies have focused on designing incentive-compatible rules aiming to achieve a private sector-led economic diversification (Rodrik 2004).

Success stories that have yielded economic diversification suggest that low, predictable and non-distorting taxes on entrepreneurial activity can help foster diversification. Also, the use of commodity proceeds to establish a supportive physical and social infrastructure can raise returns and encourage private investment in other sectors. The financial sector can also play an important role in fostering economic diversification. In particular, efforts to deepen and broaden financial systems in resource-based economies would help achieve that goal.

Institutions

Perhaps the biggest challenge facing resource-rich countries results from rent-seeking behaviour that undermines their existing institutions, including political diversification and democracy. Specifically, abundant natural resources tend to distort the allocation of talent, sometimes attracting the wrong sort of people and methods to politics. Especially in countries with weak institutions, talent tends to shift out of private entrepreneurial activity into more lucrative rent-seeking activities, with detrimental implications for efficiency and sustainable economic growth. Institutions need to be designed to guard against such developments. For example, strong and reliable property rights can foster financial-sector development, allowing the financial system to play a more active and significant role in intermediating resources to help build small- and medium-sized enterprises in the non-resource-rich sectors of the economy. Generally, more effective checks and balances and more transparency in the management of natural-resource revenues can help counteract the misallocation of talent into socially unproductive activities. It needs to be recognised that those issues are less prevalent in democratic countries with mature industrial economies than in those that were least developed as well as undemocratic at the time of mineral-resource discoveries (Arezki and Brückner 2012). This, if anything, merely underscores the importance of a careful approach to institution building.

References

Arezki, Rabah, and Markus Brückner (2012), "Effects of Commodity Price Windfalls on External Debt: The Role of Political Institutions", VoxEU.org, 15 June.

Arezki, Rabah, Thorvaldur Gylfason, and Amadou Sy, (eds.) (2012). Beyond the Curse: Policies to Harness the Power of Natural Resources (Washington, DC: International Monetary Fund).

Cabrales, Antonio and Esther Hauk (2011). "Political institutions and the curse of natural resources", VoxEU.org, 17 June.

Caselli, Francesco and Andrea Tesei (2011), "Oil and democracy: New insights", VoxEU.org, 22 December.

Das, Udaibir, Yinqiu Lu, Christian Mulder, and Amadou N. R. Sy (2009). "Setting up a Sovereign Wealth Fund: Some Policy and Operational Considerations", IMF Working Paper 09/179, August 01.

Gylfason, Thorvaldur (2008). "Norway’s Wealth: Not Just Oil", VoxEU.org, 6 June.

Rodrik, Dani, 2004, “Industrial Policy for the Twenty-First Century,“ CEPR Discussion Paper 4767, November.

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Topics:  Development Energy

Tags:  natural resources, resource curse