February 18, 2011 Leontieff Center, St. Petersburg

1. Development Based on Commodity Revenues:Theory and Russian EvidenceKonstantin Sonin,New Economic School February 18, 2011 Leontieff Center, St. Petersburg

2. Road map • Basic tradeoff: • fantastic growth in Aze, Kaz, Rus, Tkm since 1999 • volatility and a looming long run “resource curse” • Economic Growth in Resource Rich Countries • theoretical arguments and empirical evidence. • Policy Goals and Policy Tools • development strategy for resource-rich countries • Diversification Policies in Resource Rich Countries • actual policy response of countries to resource riches • Assessment • How successful were they?

3. Commodity boom underpinned growth... • Impressive growth records in oil and gas producing countries in the region • Turkmenistan, Azerbaijan, Kazakhstan, Russia • In particular in nominal (US dollar) terms

4. … but at the expense of great risks • large growth corrections during crisis: macro volatility • Potential “resource curse” affecting long run growth

5. Commodity rents and development • Commodity rents may be a blessing • developing countries fail to catch up because of an underdevelopment trap (fixed costs to investment; externalities across sectors): “big push” needed • commodity export revenues could finance such big push • Commodity rents might be a curse • depress long-run growth by causing macroeconomics distortions and excess volatility • have a negative effect on political institutions

6. Commodity rents and investment • Reliance on commodity exports • leads to high terms-of-trade volatility • discourages investment, especially if financial systems are not sufficiently developed • affects human capital (uncertain returns) • Dutch disease • underinvestment in high learning by doing technologies (manufacturing), or technologies that are otherwise particularly beneficial for long run growth

7. Macro lessons learned • in macro, little resembled petrostates of late 70s • fiscal conservatism (up until 2008) • budget control • debt repayment • stabilization funds, despite huge political pressure • mild political pressure on Central Bank (up until 2008) • control of ‘white elephants’ (up until 2007) • lesson “unlearned” by 2010

8. “Resource curse 2.0”: Institutions • Commodity resources discourage investment in good institutions • good institutions limit rent seeking • flexibility to “seek” rents is more valuable to politicians in resource-rich environment • “Institutional Trap” • if institutions are bad to start with in a resource-rich economy, they are not likely to improve • Interactions with inequality • when the same amount of rents is appropriated by fewer members of the elite, rent-seeking strategy becomes even more attractive • in resource rich environment, inequality and poor institutions are mutually reinforcing • high inequality is bad for growth (particularly with imperfect capital markets. as poor with entrepreneurial skills have no access to capital)

9. “Resource curse 2.0”: Evidence • Oil revenues have adverse impact : • on property rights (Guriev, Kolotilin, and Sonin, JLEO, 2011) • on corporate governance (Durnev and Guriev, 2009) • on media freedom (Egorov, Guriev, and Sonin, 2009) • on democracy (Ross, 2001, 2009) • on regulation and reforms to improve business climate in non-resource sectors (Amin and Djankov, 2009) • on political stability and likelihood of civil unrest (Ross, 2006)

10. Diversification 10

11. Why diversification • lowers vulnerability to external shocks • reduces relative size of resource rents and creates incentives to improve institutions (commitment device)

12. Diversification Tools: Public Investment • “Vertical” policies: preferential treatment of specific non-resource industries • difficult to get right, especially in absence of good institutions • crowd out private investment • “Horizontal” policies: investment in education, infrastructure • more likely to complement private investment • again, less efficient in weak institutional environment

13. Diversification Tools: Macro Policies • Sovereign wealth funds • prevent (in short-run) appreciation of currency or hikes in inflation, preserve (in short-run) competitiveness • smooth government expenditures over time • commitment device to prevent government’s pro-cyclical spending • could be used to finance development policies • Taxation of resource exports • per se cannot play a significant role in redirecting investment in an open economy (capital just flows to other countries, not to “right sectors”)

14. Diversification Tools: Financial Development • helps to smooth effects of resource price volatility • benefits non-resource sectors, which are more dependent on external finance (cf. Rajan-Zingales) • works as a horizontal industrial policy • helps to match entrepreneurial ideas and funding • may help reduce (effects of) inequality • instruments: • improved regulation of banks and securities markets • deposit insurance • effective court systems

15. Diversification Tools: Fighting Inequality • makes it easier to reform institutions in resource rich environments • instruments: • in developing countries typically implemented through government spending rather than taxation • ideally, through structural policies: labour mobility and education

16. Examples of Substantial Progress • Diversification away from oil and gas is challenging, but there are examples of substantial progress • Chile: competitive agriculture and fishing (wine, salmon farming) • Malaysia: high-tech manufacturing integrated into South Asian and World production chains • Indonesia: medium-to-high-tech manufacturing, agriculture • Mexico: high-tech manufacturing based primarily on FDI by US firms

17. Transition Countries • Russia and Kazakhstan made diversification cornerstone of development agenda • Public investment increased in all countries over commodity boom period • 3% to 4.5% of GDP in Russia; • 3% to 6% of GDP in Kazakhstan; • 2% to 10% of GDP in Azerbaijan. • Public spending on education: • 2.9 to 4% of GDP in Russia; • 3.3 to 4.2% of GDP in Kazakhstan

18. Policies: Financial Development • Despite fast GDP growth (e.g., 8-fold in Russia in US$ nominal terms between 1998 and 2008) credit-to-GDP ratios have been growing rapidly

19. Policies: Financial development • Rapid growth made possible due to entry of foreign banks • Especially in Kazakhstan • Loan-to-deposit ratios have been very high, well above regional average

20. Policies: Financial Development • financial sector growth was facilitated by number of structural reforms • deposit insurance, credit bureaus, interest rates disclosure, revisions to legislation on collateral and bankruptcies • non-bank finance has also been growing, albeit at a lower pace • only in Russia reforms outpaced the non-oil-rich transition country average

21. Policies: Sovereign wealth funds • Azerbaijan set up State Oil Fund in 1999 • Kazakhstan established National Fund in 2000 • Peaked at 30% of GDP (the largest in relative terms) • Russia: Stabilization Fund in 2004, subdivided into Reserve Fund and National Wealth Fund in 2008

22. Assessment 22

23. Assessment: Diversification • measures of structure of output / exports are distorted by oil price effects • directly (valuation) • indirectly (short-term incentives to produce and export) • Even Norway, Malaysia lost positions in UNIDO “Industrial Competitiveness” indices during the boom • compare oil / output structure at similar points in oil price cycle?

24. Diversification in Russia: Comparison • Comparable periods in terms of average oil price: • Dec04-Apr05 and Dec08-Apr09 • No evidence of diversification, there may be slight decline in manufacturing

25. No diversification of Russian GDP in 2002-2008

26. Structure of exports: Russia and Kazakhstan • exports structure suggests growing oil dependence in Kazakhstan and Azerbaijan • Partly reflects successful exploration, largely led by international firms (PSAs) • in Russia structure of exports was similar at similar points in the oil price cycle

27. Structure of exports: Azerbaidzhan and non-oil countries • in other transition countries share of manufacturing exports has been increasing on average

28. Assessment: Impact of Crisis • no clear link between commodity dependence and severity of the crisis on average (in terms of macro impact on growth) • indirect measure: deviation of 2009 forecast from the 1999-2008 average growth • if anything, the effect of commodity wealth is positive • all countries in the region drew on their fiscal and monetary reserves to finance sizable fiscal and monetary stimulus packages

29. Assessment: Financial Development • Financial development supported real sector, but also exacerbated commodity cycle • very high leverage • rapid consumer credit growth • credit growth averaging 50%+, up to 115%, put strain on bank risk management and on supervisors • Overall, some cross-country evidence that while financial development softened the impact of crisis, excessively high loan-to-deposit ratios exacerbated it

30. Institutions Matter 30

31. Assessment: Institutions • To look at diversification, compare export structures in 1991–92 and 2001–03 (oil at US$ 30-31 in 2008 prices) • Use share of food and higher-value-added manufacturing in exports (WTO data) • Technologically distanced from oil and gas • Bulk of developed countries’ exports (from 70% in Germany to 30% in Australia, but less than 10% in Rus, Kaz, Aze)

32. Assessment: Institutions • export structures are generally “sticky” (correlation is 0.85) • oil rents suppress diversification, but this effect becomes insignificant when quality of institutions is included • quality of institutions is statistically and economically significant • one standard deviation improvement in the quality of institutions is associated with a 4 to 6 p.p. increase in share of higher-value-added manufacturing and food in merchandize exports • relationship is even stronger in the subsample of countries with weaker institutions (index below median) • result holds in a small subsample of countries where commodities accounted for 40%+ of merchandize exports at the start of the period • financial development per se or existence of sovereign wealth fund do not appear to have significant impact

33. Assessment: Institutions • improving institutions remains a challenge

34. Corruption

35. A Russian problem… Russia is 1.04st.dev. below the line; Same if control for education, size, inequality etc… Log GDP per capita, PPP, 2005

36. Media freedom and Government Effectiveness Replay Egorov, Guriev, and Sonin (2009)

37. Media freedom and Control of Corruption Replay Egorov, Guriev, and Sonin (2009)

38. Next South Korea?

39. Institutions much worse in Russia

40. Conclusion • commodity revenues provide significant opportunities for financing investment but may also negatively affect growth • terms of trade volatility has negative impact on investment • structural shifts in accumulation/allocation of physical/human capital • incentives to engage in rent-seeking rather than improve institutions • diversification may be pursued via variety of strategies • direct investment in non-resource sectors • investment in education and infrastructure, fiscal redistribution • financial sector development • sovereign wealth funds

41. Conclusion, ctd • diversification policies can be successful, but success crucially depends on institutions • democracy, media freedom, property rights, corporate governance, low tolerance for corruption • improving these institutions is a particularly challenging task in oil-rich societies • post-communist oil-rich countries have done well in terms of prudent macro policies • financial sector development • played an important role in supporting the real sector • extraordinary financial services boom fuelled by external borrowing in part amplified the effects of the commodity cycle

42. Sources • Chapter 4 of the 2009 EBRD Transition Report • background paper “Development Based on Commodity Revenues”, with Sergei Guriev and Alexander Plekhanov • Own work on resource-dependence • Why Resource-Poor Dictators Allow Freer Media (with Georgy Egorov and Sergei Guriev), American Political Science Review, November 2009 • Determinants of Nationalizations in the Oil Sector (with Sergei Guriev and Anton Kolotilin), Journal of Law, Economics, and Organization, 2011 • Sergei Guriev and Ekaterina Zhuravskaya work • Why Russia is Not South Korea, Journal of International Affairs, 2010