Resource abundance and corporate transparency

Art Durnev, Sergei Guriev 21 November 2007

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High oil prices brought the issue of so-called “resource curse” back to the frontlines of public debate. It has long been noticed that resource abundance does not always help countries grow out of poverty; instead, they often fall victim of poor governance and internal conflicts. Moreover, among the developing countries which did close the gap with the rich countries in the recent decades, the majority have been resource-poor.

It is still not clear what exactly prevents resource-rich countries from making use of their resource endowments. The newly emerging consensus among economists is that resource abundance slows down, or may even revert, development of growth-enhancing institutions. This conjecture is no longer just an academic hypothesis. Recently, it has been widely discussed by policymakers and the media. In particular, the New York Times’ columnist Tom Friedman’s formulated it as the First Law of Petropolitics: high oil prices stifle the development of democracy and political and economic freedom in oil-rich countries.

Yet, the relationship between the resource abundance and institutions is very hard to test. Institutions change slowly, so one can only rely on cross-country comparisons (e.g. Mehlum et al. 2006 and Robinson et al. 2006). Such cross-country regressions do show that resource curse hits only the countries with underdeveloped institutions, while mature democracies (such as Norway) may actually benefit from their resource wealth. On the other hand, such regressions cannot resolve the issues of omitted variables, endogeneity, and reverse causality. For example, the US is a large oil producer but does not suffer from the resource curse exactly due to its strong institutions; indeed mature economic and political institutions have helped to develop the other sectors as well. So the causality may run from institutions to resource abundance, rather than vice versa.

Some institutions, however, do change fast. Very much in accordance with Friedman’s Law, in the recent years quite a few oil-rich governments have significantly increased their control over media. The Freedom House rates media freedom in 160 countries on the scale of 0 to 100. The standard deviation of media freedom across these countries is 24 points. Yet, just in the course of 6 years, in 2000-2006, media freedom in Iran fell by 12 points, in Russia by 15 points, and in Venezuela by 40 points. Therefore, if there is an effect of resource abundance on media freedom, it can be captured within a reasonably short period of time. Egorov et al. (2006) use the panel data for 1993-2006 to demonstrate that indeed, the oil reserves have an adverse effect on media freedom, controlling for country-fixed effects, GDP per capita, level of democracy, size of government and other relevant controls; this effect is especially strong in less democratic countries.

Still, research based on country-level variables does not allow understanding the specific channels through which the resource curse works, nor does it allow to distinguish the effects of the resource curse on different sectors of the economy. In our recent paper (Durnev and Guriev, 2007), we use microeconomic data (a panel of 72 industries from 51 countries over 16 years) to investigate the effect of resource abundance on growth through its effect on property rights and corporate transparency.

Our argument is straightforward. During the periods of high oil prices, corporate profits in the natural resource industries represent rents that are relatively easy for governments to capture. Firms in such industries face a trade-off. On the one hand, in order to attract external capital, they need to be transparent. On the other hand, higher transparency involves a greater risk of expropriation. Transparency with respect to corporate profits can attract scrutiny by politicians and various forms of government expropriation, such as the extortion of bribes, overregulation, confiscatory taxation, and the outright seizure of firm assets. Transparency would therefore be lower in industries that are more vulnerable to expropriation, particularly in countries that have poor protection of property rights, especially when oil prices are high.

This argument is not new. In the “Wealth of the Nations”, Adam Smith wrote: “In those unfortunate countries, indeed, where men are continually afraid of the violence of their superiors, they frequently bury and conceal a great part of their [capital] stock.” This issue is still highly relevant especially for the corporations operating in natural resource sectors. The quintessential example is the story of Yukos, once Russia’s largest and most transparent oil company, and Russia’s once-richest person Mikhail Khodorkovsky. Khodorkovsky and his partners acquired their stake in a notorious loans-for-shares auction and then diluted the stakes of other shareholders, including foreign investors and the government. Once they assumed control over the company, its transparency and corporate governance improved substantially. Khodorkovsky was the first of Russian oligarchs to disclose his personal stake in a major company and to invite reputable foreigners to join his corporate board. This raised Yukos market capitalisation fifteen-fold in less than four years, but also eventually resulted in the full expropriation by the government and imprisonment and exile of the key owners and managers. While the official charges against Khodorkovsky were related to tax fraud, there is a widespread belief that the government’s assault was driven by a combination of his political ambitions and the firm’s openness about its high value. As a member of Russian parliament and a former colleague of Khodorkovsky said, “He created what others had failed to create: a transparent, Western-style-of-management company which already had a positive international image”(Los Angeles Times, December 19, 2004).

The lessons from the Yukos affair were immediately understood by other Russian oil companies. As one of the harshest critics of Khodorkovsky (William Browder, the head of the Hermitage Capital Investment Fund in Russia) acknowledged in the aftermath of the Yukos affair: “… the threat of nationalization is forcing companies to go backward with their corporate governance.” Goriaev and Sonin (2006) document that investors perceived the attacks on Yukos as a strong signal that the state would expropriate other Russian companies as well. They show that the reaction to the Yukos affair was more negative for the stocks of more transparent companies than for those of less transparent ones.

The relevance of this argument goes well beyond Russia. Our analysis shows that around the world, corporations in oil-related sectors do reduce their transparency whenever oil prices are high and governments are predatory. Controlling for country, year, and industry-fixed effects, we find that corporate transparency is lower in more oil-price-dependent industries when the price of oil is high and property rights are poorly protected. In turn, lower transparency in oil-price-sensitive industries results in less efficient capital allocation and eventually in lower corporate growth.

Figure 1: Differential corporate opacity of oil and gas extraction industries relative to other industries plotted against country predation index. Differential aggregate opacity is the difference between median opacity (across firms and years from 1990 through 2005) of firms in oil and gas extraction and the median aggregate opacity of all other firms.

Our results are economically significant. Based on regression results, we can compare growth rates of more expropriation-sensitive industries (e.g., oil and gas extraction), growth rates of industries with little expropriation risk (e.g., agriculture) depending on the level of country predation. Consider a country with a predatory country (e.g., Venezuela) and another country with high-quality institutions (e.g., Norway). The oil and gas extraction industry in Venezuela would grow slower by 1.8 % compared to agriculture. On the other hand, in Norway, the differential growth rate between oil and gas extraction and agriculture would be only 0.1%.

Our work therefore supports the emerging consensus that slower growth in resource-rich economies may be explained by the negative impact of resource endowments on the development of economic and political institutions, which in turn suppresses economic growth. We show that it is not an abstract theory; nor should the existing cross-country comparisons be disregarded as a coincidence or a spurious correlation. It turns out that resource curse is indeed a corporeal phenomenon. It affects – in a very tangible way – corporate transparency in actual corporations. This in turn results in material consequences for capital allocation and growth of these firms.

References

Durnev, Art, and Sergei Guriev, 2007, “The Resource Curse: A Corporate Transparency Channel.” CEPR DP 6547.

Egorov, Georgy, Sergei Guriev, and Konstantin Sonin, 2007, Media freedom, bureaucratic incentives, and the resource curse, CEPR DP 5748 .

Goriaev, Alexei, and Konstantin Sonin, 2005 “Is Political Risk Company-Specific? The Market Side of the Yukos Affair.” CEPR DP 5076.

Friedman, Thomas. 2006. “The First Law of Petropoltics." Foreign Policy 154:28-39.

Mehlum, Halvor, Karl Ove Moene, and Ragnar Torvik , 2006, Institutions and the resource curse, Economic Journal 116, 1-20.

Robinson, James, Ragnar Torvik, and Thierry Verdier, 2006, Political foundations of the resource curse, Journal of Development Economics 79, 447-468.

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Topics:  Development Politics and economics

Tags:  development, oil prices, corporate transparency, resource endowments

Assistant Professor of Finance at the Faculty of Management at McGill University

Associate Professor and Rector, New Economic School, Moscow and CEPR Research Affiliate