Transcript The Natural Resource Curse and How to Avoid It Jeffrey Frankel Harpel Professor of Capital Formation & Growth IMF Institute for Capacity Development (formerly.

The Natural Resource Curse
and How to Avoid It
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth
IMF Institute for Capacity Development (formerly IMF Institute)
July 27, 2012
The Natural Resource Curse
Part I: Channels
 Some

seminal references:

Auty (1990, 2001, 2007)

Sachs & Warner (1995, 2001),
By now there is a large body of research,

which I have surveyed
(2011, 2012a, b).
2

Many countries that are
richly endowed with oil,
minerals, or fertile land
have failed to grow more
rapidly than those without.

Example:

Some studies find a negative effect of oil
in particular, on economic performance:


including Kaldor, Karl & Said (2007); Ross (2001);
Sala-i-Martin & Subramanian (2003); and Smith (2004).
Some oil producers in Africa & the Middle East
have relatively little to show for their resources.

Meanwhile, East Asian economies
achieved western-level standards of living
despite having virtually no exportable
natural resources:

Japan, Singapore, Hong Kong, Korea & Taiwan,


rocky islands or peninsulas;
followed by China.
Growth falls with fuel & mineral exports
5
Are natural resources necessarily bad?
No, of course not.


Commodity wealth need not necessarily lead
to inferior economic or political development.
Rather, it is a double-edged sword,
with both benefits and dangers.


It can be used for ill as easily as for good.
The priority should be on identifying ways
to sidestep the pitfalls that have afflicted
commodity producers in the past,
to find the path of success.
6




Some developing countries have avoided
the pitfalls of commodity wealth.

E.g., Chile (copper)

Botswana (diamonds)
Some of their innovations are worth emulating.
The 2nd half of the lecture will offer some policies
& institutional innovations to avoid the curse:
especially ways of managing price volatility.


Some lessons apply to commodity importers too.
Including lessons of policies to avoid.
7



But, 1st: How could abundance
of commodity wealth be a curse?
What is the mechanism
for this counter-intuitive relationship?
At least 5 categories of explanations.
8
5 Possible Natural Resource Curse Channels
1.
Volatility
2.
Crowding-out of manufacturing
3.
Autocratic Institutions
4.
Anarchic Institutions
5.
Procyclicality
1.
2.
3.
including
Procyclical capital flows
Procyclical monetary policy
Procyclical fiscal policy.
9
I have chosen to exclude a 6th channel,
The Prebisch-Singer (1950) Hypothesis


that commodities supposedly suffer
a long-run downward relative price trend.
Vs. persuasive theoretical arguments
that we should expect commodity prices
to show upward trends in the long run


Malthus
Hotelling
The trend since 1960 has been up
Commodity prices: all commodities
Indices
A.Saiki, Dutch Nat.Bk.
180
160
140
120
100
80
60
40
20
0
60 61 63 64 66 67 69 71 72 74 75 77 79 80 82 83 85 86 88 90 91 93 94 96 98 99 01 02 04 05 07 09 10
Nominal
in prices of 2010
prices
*) Deflated by US consumer price2010=100
index.
Source: HWWA, Datastream.
Real prices *
In prices
of 2000*
= nominal
in 2000
(1) Volatility
in global commodity
prices arises because
supply & demand are
inelastic in the short run.
12
Commodity prices have been especially
volatile over the last decade
Source: UNCTAD
Effects of Volatility

Volatility per se can be bad for economic growth.




Hausmann & Rigobon (2003), Blattman, Hwang, & Williamson (2007),
and Poelhekke & van der Ploeg (2007).
Risk inhibits private investment.
Cyclical shifts of resources back & forth across
sectors may incur needless transaction costs.
=> role for government intervention?


On the one hand, the private sector dislikes risk as
much as government does & takes steps to mitigate it.
On the other hand the government
cannot entirely ignore the issue of volatility;

e.g., exchange rate policy.
14
2. Natural resources may
crowd out manufacturing,


and manufacturing could be the sector
that experiences learning-by-doing

or dynamic productivity gains from spillover.

Matsuyama (1992), van Wijnbergen (1984) and Sachs & Warner (1995).
So commodities could in theory be a dead-end sector.


=> Mere “hewers of wood and drawers of water” remain
forever poor (Deuteronomy 29:11) if they do not industrialize.
My own view: a country need not repress the
commodity sector to develop the manufacturing sector.

It can foster growth in both sectors.

E.g. Canada, Australia, Norway… Now Malaysia, Chile, Brazil…
3. Autocratic or oligarchic institutions
may retard economic development.

Countries where physical command of natural
resources by government or a hereditary elite
automatically confers wealth on the holders


are likely to become rent-seeking societies;
and are less likely to develop the institutions
conducive to economic development,


e.g., decentralization & economic incentives;
as compared to countries where moderate
taxation of a thriving market economy is the only
16
way government can finance itself.
Econometric findings that oil
and other “point-source resources”
lead to poor institutions





Isham, Woolcock, Pritchett, & Busby
Sala-I-Martin & Subramanian (2003)
Bulte, Damania & Deacon (2005)
Mehlum, Moene & Torvik (2006)
Arezki & Brückner (2009).
(2005)
The theory is thought to fit Middle Eastern oil exporters
well.
E.g., Iran. Mahdavi (1970), Skocpol (1982, p. 269), and Smith (2007).
What are poor institutions?
A
typical list:
 inequality,
 corruption,
 intermittent
dictatorship,
 ineffective judiciary branch, and
 lack of constraints to prevent elites &
politicians from plundering the country.
The “rent cycling theory”
as enunciated by Auty



(1990, 2001, 07, 09)
:
Economic growth requires recycling rents
via markets rather than via patronage.
In oil countries the rents elicit
a political contest to capture ownership,
whereas in low-rent countries the government
must motivate people to create wealth,

e.g., by pursuing comparative advantage,
promoting equality, & fostering civil society.
An example, from economic historians
Engerman & Sokoloff

Why did industrialization take place in North America,





(1997, 2000, 2002)
not the South?
Lands endowed with extractive industries & plantation crops
developed slavery, inequality, dictatorship, and state control,
whereas those climates suited to fishing & small farms
developed institutions of individualism, democracy,
egalitarianism, and capitalism.
When the Industrial Revolution came, the latter areas
were well-suited to make the most of it.
Those that had specialized in extractive industries were not,

because society had come to depend on class structure & authoritarianism,
rather than on individual incentive and decentralized decision-making.
4. Anarchic institutions
1.
2.
3.
Unsustainably rapid
depletion of resources
Unenforceable
property rights
Civil war
21
4.1 Unsustainably
rapid depletion
When exhaustible resources
are in fact exhausted,
the country may be left with nothing.

Three concerns:


Protection of environmental quality.

A motivation for a strategy of economic diversification.

The need to save for the day of depletion

Invest rents from exhaustible resources in other assets.

Hartwick (1977) and Solow (1986).
22
The example of Nauru
phosphate mining
4.2 Unenforceable property rights

Depletion would be much less of a problem
if full property rights could be enforced,




thereby giving the owners incentive
to conserve the resource in question.
But often this is not possible
 especially under frontier conditions.
Overfishing, overgrazing, & over-logging are classic
examples of the “tragedy of the commons.”
Individual fisherman, ranchers, loggers, or miners,
have no incentive to restrain themselves, while the
fisheries, pastureland or forests are collectively depleted.
24
Madre de Dios region of the Amazon rainforest in Peru,
the left-hand side stripped by illegal gold mining.
http://indiancountrytodaymedianetwork.com/2011/02/27/amazon-gold-rush-laying-waste-to-peruvian-rainforest%E2%80%99s-madre-de-dios-20021
4.3 War

Where a valuable resource such as oil or diamonds
is there for the taking, factions will likely fight over it.

Oil & minerals are correlated with civil war.

Fearon & Laitin (2003), Collier & Hoeffler (2004),
Humphreys (2005) and Collier (2007).

Chronic conflict in places
such as Sudan comes to mind.

Civil war is, in turn, very bad
for economic development.
26
(5) Procyclicality


The Dutch Disease describes unwanted
side-effects of a commodity boom.
Developing countries are
historically prone to procyclicality,


especially commodity producers.
Procyclicality in:



Capital inflows; Monetary policy;
Real exchange rate; Nontraded Goods
Fiscal Policy
27
The Dutch Disease:
5 side-effects of a commodity boom

1) A real appreciation in the currency

2) A rise in government spending

3) A rise in nontraded goods prices

4) A resultant shift of production
out of manufactured goods

5) Sometimes a current account deficit
28
The Dutch Disease: The 5 effects elaborated
 1)


taking the form of nominal currency appreciation
if the exchange rate floats
or the form of money inflows, credit
& inflation if the exchange rate is fixed;
 2)

Real appreciation in the currency
A rise in government spending
in response to availability of tax receipts or royalties.
29
The Dutch Disease: 5 side-effects of a commodity boom

3) An increase in nontraded goods prices
relative to internationally traded goods

4) A resultant shift out of
non-commodity traded goods,


esp. manufactures,
pulled by the more
attractive returns
in the export commodity
and in non-traded goods.
30
The Dutch Disease: 5 side-effects of a commodity boom

5) A current account deficit,
 as

booming countries attract capital flows,
thereby incurring international debt that
is hard to service when the boom ends.

Manzano & Rigobon (2008): the negative Sachs-Warner effect of

Arezki & Brückner (2010a, b): commodity price booms lead to higher
resources on growth rates during 1970-1990 was mediated through
international debt incurred when commodity prices were high.
government spending, external debt & default risk in autocracies,



but do not have those effects in democracies.
the dichotomy extends also to effects on sovereign bond spreads.
But many developing countries avoided borrowing in the 2003-11 boom.
31
Procyclical capital flows

According to intertemporal optimization theory,
capital flows should be countercyclical:



In practice, it does not always work this way.
Capital flows are more procyclical than countercyclical.


Net capital inflows when exports are doing badly
And net capital outflows when exports do well.
Gavin, Hausmann, Perotti & Talvi (1996); Kaminsky, Reinhart & Vegh
(2005); Reinhart & Reinhart (2009); and Mendoza & Terrones (2008).
Invalidates much of existing theory,


though certainly not all.
Theories to explain this involve
capital market imperfections,

e.g., asymmetric information or the need for collateral.
Procyclical monetary policy

If the exchange rate is fixed,

surpluses during commodity booms
lead to rising reserves and money supply.



possibly delayed by sterilization attempts.
Example: Gulf States during recent oil booms.
Floating can help, accommodating trade shock.

But,


under pure floating: appreciation can be excessive.
under IT: CPI rule says to tighten money & appreciate when
import commodity price goes up (or other adverse supply shock).
 That’s backwards. (E.g., oil importers in 2008.)
 Should appreciate when export commodity price goes up.
Procyclical real exchange rate
Countries undergoing a commodity boom
experience real appreciation of their currency

taking the form of nominal currency appreciation

for floating-rate commodity exporters,
Colombia, Kazakhstan, Russia, S.Africa, Chile, Brazil….

or the form of money inflows & inflation

for fixed-rate commodity exporters,
Saudi Arabia & UAE….
OK. But real appreciation adds to boom in NTGs.
Procyclical fiscal policy

Fiscal policy has historically tended
to be procyclical in developing countries

especially among commodity exporters:
Cuddington (1989), Tornell & Lane (1999), Kaminsky, Reinhart &
Vegh (2004), Talvi & Végh (2005), Alesina, Campante & Tabellini
(2008), Mendoza & Oviedo (2006), Ilzetski & Vegh (2008), Medas
& Zakharova (2009), Gavin & Perotti (1997).


Correlation of income & spending mostly positive –

particularly in comparison with industrialized countries.
The procyclicality of fiscal policy

A reason for procyclical public spending:
receipts from taxes & royalties rise in booms.
The government cannot resist the temptation
to increase spending proportionately, or more.

Then it is forced to contract in recessions,

thereby exacerbating the swings.
36
Two budget items account for much
of the spending from oil booms:

(i) Investment projects.

Investment in practice may be
“white elephant” projects,

which are stranded without funds
for completion or maintenance
when the oil price goes back down.


Gelb (1986).
Rumbi Sithole took this photo
in “Bayelsa State
in the Niger Delta,in Nigeria.
The state government
received a windfall of money
and didn't have the capacity
to have it all absorbed in
social services so they decided
to build a Hilton Hotel.
The construction company
did a shoddy job, so the tower
is leaning to its right and
it’s unsalvageable..”
(ii) The government wage bill.

Oil windfalls are often spent on public sector wages.


Medas & Zakharova (2009)
Arezki & Ismail (2010):
government spending rises in booms, but is downward-sticky.
37
Correlations between Gov.t Spending & GDP
1960-1999
procyclical
Adapted from Kaminsky, Reinhart & Vegh (2004)
countercyclical
G always used to be pro-cyclical
for most developing countries.
The procyclicality of fiscal policy, cont.


Procyclicality has been especially strong
in commodity-exporting countries.
An important development -some developing countries, including
commodity producers, were able to break
the historic pattern in the most recent decade:

taking advantage of the boom of 2002-2008



to run budget surpluses & build reserves,
thereby earning the ability to expand
fiscally in the 2008-09 crisis.
Chile is the outstanding model.

Also Botswana, China, Indonesia, Korea…
39
Correlations between Government spending & GDP
2000-2009
procyclical
Frankel, Vegh & Vuletin (2012)
countercyclical
In the last decade,
about 1/3 developing countries
switched to countercyclical fiscal policy:
Negative correlation of G & GDP.
Summary of Part I

Five broad categories of hypothesized channels
whereby natural resources can lead to poor economic
performance:





commodity price volatility,
crowding out of manufacturing,
autocratic institutions,
anarchic institutions, and
procyclical macroeconomic policy, including




capital flows,
monetary policy and
fiscal policy.
But the important question is how to avoid the pitfalls,

to achieve resource blessing instead of resource curse.
42
Appendix: I chose to exclude a 6th channel,
The Prebisch-Singer (1950) Hypothesis

that commodities supposedly suffer
a long-run downward relative price trend.


Theoretical reasoning: world demand for primary
products is inelastic with respect to income.
Vs. persuasive theoretical arguments
that we should expect commodity prices
to show upward trends in the long run


Malthus (esp. for food)
Hotelling (for depletable resources).

The up trend idea goes back to Malthus (1798)
and early fears of environmental scarcity:
Demand grows with population (geometrically),
 Supply does not.
 What could be clearer in economics
than the prediction that price will rise?

Hotelling

Firms choose how fast to extract oil or minerals



(1931)
King Abdullah of Saudi Arabia, with interest rates ≈ 0 in
2008,
apparently believed that the rate of return on oil reserves
was higher if he didn't pump than if he did:
"Let them remain in the ground for
our children and grandchildren..."
Arbitrage =>

expected rate of price increase = interest rate.
The empirical evidence


With strong theoretical arguments on both sides,
either for an upward trend or for a downward
trend, it is an empirical question.
Terms of trade for commodity producers had





a slight up trend from 1870 to World War I,
a down trend in the inter-war period,
up in the 1970s,
down in the 1980s and 1990s,
and up in the first decade of the 21st century.
What is the overall statistical trend
in commodity prices in the long run?



Some authors find a slight upward trend,
some a slight downward trend. [1]
The answer depends on the date
of the end of the sample.
[1] Cuddington (1992), Cuddington, Ludema & Jayasuriya (2007), Cuddington
& Urzua (1989), Grilli & Yang (1988), Pindyck (1999), Reinhart & Wickham
(1994), Hadass & Williamson (2003), Kellard & Wohar (2005), Balagtas &
Holt (2009), Cuddington & Jerrett (2008), and Harvey, Kellard, Madsen &
Wohar (2010).