The Natural Resource Curse and How to Avoid It

1. The Natural Resource Curse and How to Avoid It Part I: Channels of the commodity curse Part II: Policies & institutions to avoid the pitfalls MPA/ID extra lecture, Dec. 18, 2013 Jeffrey Frankel

2. The NaturalResourceCursePart 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).

3. 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.

4. Meanwhile, East Asian economies achieved western-level standards of living despite having virtually no exportable natural resources: Japan, Singapore, HongKong, Korea&Taiwan, rocky islands or peninsulas; followed by China.

5. Growth falls with fuel&mineral exports

6. Are natural resources necessarily bad? No, of course not. • Commodity wealth neednot 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 haveafflictedcommodityproducers in the past, to find the path of success.

7. 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.

8. 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.

9. 5 Possible Natural Resource Curse Channels • Volatility • Crowding-out of manufacturing • Autocratic Institutions • Anarchic Institutions • Procyclicalityincluding • Procyclical capital flows • Procyclical monetary policy • Procyclical fiscal policy.

10. (1) Volatility in global commodity prices arises because supply & demand are inelastic in the short run.

11. Commodity prices have been especially volatile over the last decade Source: UNCTAD

12. Effects of Volatility Volatility per se can be bad for economic growth. Hausmann & Rigobon(2003),Blattman, Hwang, & Williamson (2007), and Poelhekke & van derPloeg(2007). Risk inhibits private investment. Cyclical shifts of labor, land & capital back & forth across sectors may incur needless 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. 12

13. 2. Natural resources may crowd outmanufacturing, • and manufacturing could be the sector that experiences learning-by-doing • or dynamic productivity gains from spillover. • Matsuyama (1992),vanWijnbergen (1984)andSachs&Warner (1995). • So commodities could in theory be a dead-end sector. • My own view: a country need not repress the commoditysector to develop the manufacturingsector. • It can foster growth in both . • E.g. Canada, Australia, Norway… Now Malaysia, Chile, Brazil…

14. Econometric findings that oiland other “point-source resources”lead to poor institutions • Isham,Woolcock, Pritchett, & Busby (2005) • Sala-I-Martin & Subramanian (2003) • Bulte, Damania & Deacon (2005) • Mehlum, Moene & Torvik (2006) • Arezki & Brückner (2009). • The theory is thought to fit Mideastern oil exporters well.

15. What are poor institutions? • A typical list: • inequality, • corruption, • rent-seeking, • intermittent dictatorship, • ineffective judiciary branch, and • lack of constraints to prevent elites & politicians from plundering the country.

16. An example, from economic historians Engerman & Sokoloff(1997, 2000, 2002) • Why did industrialization take place in North America, • 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.

17. 4. Anarchic institutions Unsustainably rapid depletion of resources Unenforceable property rights Civil war See Appendix 2 for elaboration on each. 17

18. (5) Procyclicality The Dutch Disease describes unwanted side-effects of a commodity boom. Developing countries are historically proneto procyclicality, especially commodity producers. Procyclicality in: Capital inflows; Monetary policy; Real exchangerate; Nontraded Goods Fiscal Policy 18

19. 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 19

20. The Dutch Disease: The 5 effects elaborated 1) Real appreciation in the currency 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) A rise in government spending in response to availability of tax receipts or royalties. 20

21. The Dutch Disease: 5 side-effects of a commodity boom 3) An increase in nontraded goods pricesrelative 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. 21

22. 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 resources on growth rates during 1970-1990 was mediated through international debt incurred when commodity prices were high. Arezki & Brückner(2010a, b): commodity price booms lead to higher government spending, external debt & default risk in autocracies, but do not have those effects in democracies. 22

23. Procyclical capital flows • According to intertemporal optimization theory, capital flows should be countercyclical: • net capital inflows when exports are doing badly • and net capital outflows when exports do well. • In practice, it does not always work this way. Capital flows are more procyclical than countercyclical. • 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.

24. 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.

25. Procyclical real exchange rateCountries 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.

26. 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.

27. 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. 27

28. Two budget items account for much of the spending from oil booms: (i) Investment projects. Investment in practice may be “whiteelephant” projects, which are stranded without funds for completion or maintenance when the oil price goes back down. Gelb (1986). (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. Rumbi Sithole took this photo in “Bayelsa Statein 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..” 28

29. 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.

30. 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… The procyclicality of fiscal policy,cont. 30

31. Correlations between Government spending & GDP 2000-2009 procyclical Frankel, Vegh & Vuletin(2012) In the last decade, about 1/3 developing countries switched to countercyclical fiscal policy:Negative correlation of G & GDP. countercyclical

32. 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.

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34. Appendix 1: I 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).

35. 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?

36. Hotelling (1931) • Firms choose how fast to extract oil or minerals • 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.

37. 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.

38. 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).

39. 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 astrategy 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). Appendix 2: Elaboration on Anarchy:insufficient protection of property rights 39

40. The example of Nauruphosphate mining

41. 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. 41

42. 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

43. 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. 43

44. Appendix 3:The NRC SkepticsWhich comes first, oil or institutions? • Some question the assumption that oil discoveries are exogenous and institutions endogenous. • Oil wealth is not necessarily the cause and institutions the effect, rather than the other way around. • Norman (2009): the discovery & development of oil is not purely exogenous, but rather is endogenous with respect to the efficiency of the economy.

45. The important determinant is whether the country already has good institutions at the time that oil is discovered, in which case it is put to use for the national welfare, instead of the welfare of an elite. • Mehlum, Moene & Torvik (2006), • Robinson, Torvik & Verdier (2006), • McSherry (2006), • Smith (2007) and • Collier & Goderis (2007).

46. Skeptics argue that commodity exports are endogenous. • On the one hand, basic trade theory says:A country may show a high mineral share in exports, not necessarily because it has a higher endowment of minerals than others (absolute advantage) but because it does not have the ability to export manufactures (comparative advantage). • This could explain negative statistical correlations between mineral exports and economic development, • invalidating the common inference that minerals are bad for growth. • Maloney(2002)andWright & Czelusta(2003, 04, 06).

47. Commodity exports are endogenous,continued. • On the other hand, skeptics also have plenty of examples where successful institutions and industrialization went hand in hand with rapid development of mineral resources. • Countries that were able to develop efficiently their resource endowments as part of strong economy-wide growth include: • the USA during its pre-war industrialization period • David & Wright (1997). • Venezuela from the 1920s to the 1970s, Australia since the 1960s, Norway since 1969 oil discoveries, Chile since adoption of a new mining code in 1983, Peru since a privatization program in 1992, and Brazil since lifting restrictions on foreign mining participation in 1995. • Wright & Czelusta (2003, pp. 4-7, 12-13, 18-22).

48. Commodity exports are endogenous,continued. • Examples of countries that were equally well-endowed geologically but that failed to develop their natural resources efficiently include: • Chile & Australia before World War I, • and Venezuela since the 1980s. • Hausmann (2003, p.246):“Venezuela’s growth collapse took place after 60 years of expansion, fueled by oil. If oil explains slow growth, what explains the previous fast growth?”

49. Addendum: Countries with high resourcerents (as%of GDP) tend to have lower student math performance(statistically significant at the .003 level) Source: OECD education data featured in  Knowledge and skills are infinite – oil is not by Andreas Schleicher.

50. Part II Policies & institutions to avoidpitfalls oftheNaturalResourceCurse • Some that are not recommended: • Institutions that try to suppress price volatility. • Recommended: • Devices to hedge risk. • Ideas to reduce macroeconomic procyclicality. • Institutions for better governance.