Abu Dhabi, UAEMonday 23 November 2020

Economics 101: How the ‘resource curse’ works and how to avoid it

In a four-part series in The National, the economist Omar Al Ubaydli has explored the “resource curse”, by which countries can find themselves first blessed and then cursed by bountiful natural resources. He explains both how the curse works, and how best to avoid it.

In a four-part series in The National, the economist Omar Al Ubaydli has explored the “resource curse”, by which countries can find themselves first blessed and then cursed by bountiful natural resources. He explains both how the curse works, and how best to avoid it.

Part 1: The curse

Resource-rich countries across the world, including in the GCC, are often described as suffering from the “resource curse”, whereby a fortuitous endowment of natural resources, such as oil or gold, ends up having an adverse effect on the economy. Among laypeople, this view has been popularised by films such as Blood Diamond, depicting economies destroyed by the conflict that natural resources can spawn.

Much has been written about the resource curse, yet there are many misconceptions about the mechanisms underlying the phenomenon, especially a manifestation commonly referred to as “Dutch disease”, which is one of many explanations for the occasional economic underperformance of resource-rich countries.

To understand Dutch disease, we first need to understand the relationship between the trade balance and the exchange rate. In a country with a flexible exchange rate, when exports exceed imports, known as a current account surplus, then there is a net outflow of the country’s currency, or equivalently, there is a net inflow of foreign currencies.

This cannot go on forever, as the country’s currency would be depleted. Thus, like all competitive markets, the price of the currency will rise to bring net outflows closer to zero, known as currency appreciation: as the value of the currency rises, the price that foreigners pay for exports rises, making them less attractive to foreigners, and the price that domestic people pay for imports falls, making them more attractive, balancing the current account. Conversely, trade deficits create downward pressure on a country’s currency.

Now imagine that a country with a flexible exchange rate and a balanced current account suddenly discovers a huge oilfield, and starts exporting large amounts of oil. Initially, this will disrupt the trade balance, as exports will exceed imports; over time, the exchange rate will appreciate, and the current account will rebalance. Dutch disease is a two-part problem.

First, all exporting industries will suffer declining demand for their output as the exchange rate rises. Thus, compared to the situation before the arrival of oil, oil exports rise, but at the expense of non-oil exports. This non-oil contraction constitutes the stationary component of Dutch disease, also known as oil “crowding out” non-oil exports.

Second, oil (and other natural resources) tend to be industries with low employment, low levels of technological progress, and low knowledge linkages with other industries, which makes them comparatively unattractive drivers of growth within an economy. In contrast, exporting conventional manufacturing goods is considered desirable, because the sector is labour intensive (direct job creation). Moreover, the sector regularly witnesses productivity improvements, and R&D conducted in the area can be usefully applied to other sectors, boosting the rest of the economy indirectly.

Thus, shifting the economy away from manufacturing toward oil can result in a decline in job growth and a diminution of broadly beneficial technological progress. These long-term costs constitute the dynamic component of Dutch disease.

Since the Dutch disease mechanism relies upon movements in the value of a country’s currency, the most straightforward countermeasure is to neutralise the exchange rate, for example by operating a fixed exchange rate regime. The Dutch attempted some countervailing currency manipulation once they had assessed that the expensive Guilder (the former Dutch currency) was stalling the economy, by lowering interest rates, but the plan was ineffective as it encouraged domestic capital to flee the Netherlands in search of higher returns elsewhere.

In countries with a fixed exchange rate – including the GCC countries, which peg their currencies to the US dollar – when a trade surplus emerges due to oil exports, the government and central bank simply accumulate foreign currencies without spending them, often depositing them in foreign assets (such as foreign bonds and shares). Moreover, they may choose to print money to artificially engineer a countervailing downward pressure on the exchange rate.

During the sustained period of high oil prices (2005-14), GCC currencies would definitely have appreciated had they been flexible. As it happens, even in the event of an appreciation, the GCC countries do not have any substantial, exporting manufacturing industries that will contract, meaning that Dutch disease is a non-issue in the GCC.

More generally, it should be noted that the concept of a resource curse implicitly refers to economies that would be thriving were it not for the discovery of the natural resources. By virtue of their desert climates, the GCC countries would have a hard time operating anything close to a modern economy were it not for oil. For centuries, the indigenous peoples of the GCC region have toiled in arguably the toughest conditions known to man, a far cry from the temperate conditions and fertile lands of the Netherlands.

Despite their inevitable, climate-induced dependence upon oil, the GCC countries still have a variety of ways of structuring their economies. The emphasis on top-down diversification in all of the GCC economic visions suggests that, left to its own devices, the private sector is not best placed to take advantage of the opportunities offered by natural resources, for reasons that mimic some of the alternative resource curse mechanisms discussed in the literature. We explore these below ...

Part 2: Volatility

In a globalised economy, the benefits of a natural resource boom are amplified by countries exporting most of these resources in exchange for imports of consumption and investment goods. For example, Qatar sells its natural gas to countries such as Japan, and uses the proceeds to buy the Toyota Landcruisers that are such a common sight in Doha, as well as the materials and foreign expertise necessary to build the stadiums for the 2022 Fifa World Cup.

A problem arises if natural resource exports are the dominant source of income in the economy, because global commodity prices are quite volatile, meaning that the volatility is transmitted to the economy.

For example, at the start of 2017, oil was at about US$55 a barrel; in January last year, it was around $30 a barrel; two years ago, in January 2014, it was $110 a barrel. In the early 2000s, it was below $20 a barrel.

For an oil exporter such as the UK, these gyrations are of limited consequence because oil profits accounted for 0.2 per cent of GDP in 2015, but in Kuwait, the corresponding figure was 39 per cent.

Why is volatility undesirable? Because the primary source of economic growth is investment, especially long-sighted projects such as infrastructure and R&D, and investment planning becomes very difficult when the economy is fundamentally unstable. Can you imagine how challenging it would be to take on a mortgage if your income could double or half from year to year? Inevitable, you would have to settle for a much smaller house than the one that you would seek with a stable income.

This problem is especially acute in the exports sector, which is a key source of jobs in advanced economies. Global markets are intensely competitive, and small changes in costs and prices can have profound consequences for the market share of an exporter. Natural resource volatility affects the availability of capital for prospective exporters, as well as inducing significant undulations in the exchange rate, further impairing investors’ ability to put together a coherent, implementable plan. Substantial volatility, therefore, typically results in low investment, and an emphasis on short-term projects at the expense of the ones that bear fruit over decades.

Can resource-dependent countries dampen the volatility? A favoured countermeasure is to invest resource proceeds heavily in foreign assets that deliver returns that are far more stable than the prices of global commodities. This is why the GCC countries have established huge sovereign wealth funds, buying billions of dollars of foreign bonds, shares and property. Norway, owner of the biggest fund, places strict restrictions on how much of the resulting income and accumulated capital can be used year-to-year.

Ultimately, there are limits to the amount of hedging that can be done, because commodity prices are “non-stationary”, meaning that they do not fluctuate around a stable mean; instead, they tend to meander in a completely unpredictable fashion, and so policymakers can never tell if current prices are actually high or low looking forward.

Moreover, citizens exhibit their human nature by placing political pressure upon governments to consume the fruits of a resource boom in the present, rather than saving it for future generations, further limiting policymakers’ efforts at stabilising the economy.

Therefore, a critical step towards ensuring the beneficence of natural resources is diversifying the economy, which is why there are no mentions of the resource curse in generously endowed countries such as Australia and the US.

Part 3: Jobs distortion

Natural resources can lead to underinvestment in education – but what is the precise mechanism? The key is public sector hiring, which distorts labour markets and the market for education.

In countries with a large natural resource income that accrues to the government, public sector employment is one of the most straightforward ways of raising living standards. This medium was doubly attractive in the Gulf countries during the 20th century because the departure of the British created a need for an expanded civil service. Today, in many resource- rich countries, including the GCC, over 50 per cent of employed nationals work for the government.

The problem with public sector jobs, however, is that most are administrative, and it is difficult to measure the value of the associated tasks. The private sector also faces the same problem, but companies typically have profits that help management to gauge a worker’s contribution. In the public sector, the difficulty of measuring productivity is accentuated by the fact that the organisation does not generate conventional revenues, nor does it target profits.

As a result, governments face great difficulty in determining an appropriate wage for these workers, since the typical solution of setting remuneration equal to a worker’s contribution to profit does not apply.

The standard remedy is to benchmark wages to the private sector: devise a systematic way of measuring a worker’s skills and qualifications, see what such a profile usually earns in the private sector, and use that as the basis for the public sector wage.

The problem with this solution is that most benchmarking systems do not distinguish between different educational specialisations. In the public sector, human resources departments treat a doctorate in cultural anthropology as equally valuable to a doctorate in mechanical engineering, even for a position that requires technical skills.

Ultimately, this is due to the instability of the market values of differing specialisations. The pressure of profitability forces private sector companies to nimbly adjust to market dynamics, but governmental organisations are much slower to adapt.

As a result, public sector hiring standards and salary benchmarking gives workers an incentive to acquire educational qualifications, but not necessarily those that are genuinely valuable in the global economy. That is why it is common for public sector workers to get a MA in their favourite subject, or in one that is relatively easy, and to then demand a pay raise, without any regard for whether their newly acquired skills enhance their productivity — a wasteful form of credentialism. In the private sector, workers do not dare make such outrageous demands, preferring to enrol in programs designed to help raise their job performance.

In many countries, this problem is confined due to the limited size of the public sector. However, in resource-rich countries, government domination of employment leads to an educational market that does not satisfy the needs of a modern economy. Consequently, entire generations of citizens end up investing in qualifications that would yield very small returns in global markets, tantamount to underinvestment in valuable education.

This is one of the reasons why the GCC countries now place such an emphasis on boosting private sector hiring at the expense of public sector jobs, a strategy that will unquestionably improve the economy in the long-run. The former UK prime minister Tony Blair once chanted: “Education! Education! Education!” Resource-rich countries should adopt the slogan: “Productivity! Productivity! Productivity!”

Part 4: War

At a fundamental level in an economy, there are two ways for an individual to improve their standard of living: resource production, and resource expropriation.

Resource production refers to creating value by manufacturing goods and delivering services that others voluntarily acquire in exchange for their own goods and services, or for money that can be used to purchase goods and services from third parties. Think of a fisherman catching fish, selling it in the market and using the proceeds to feed and clothe his family.

Resource expropriation refers to seizing the value created by others, by physical coercion, also known as banditry. It includes pirates boarding a ship and acquiring its cargo under the threat of violence.

Resource production is about enlarging the economic pie, whereas resource expropriation is about redistributing the pie without growing it, and possibly by shrinking it, as violence often destroys value – think of a burglar damaging your house as he steals your possessions. Therefore a successful economy will have as much production and as little expropriation as possible; how can we minimise banditry?

The incentive to expropriate others is based on two factors: the size of the prize, and the punishment in case of failure. All governments strive to punish those who seek to seize the property of others, but no legal system can provide perfect protection. The problem in resource-rich countries is that the prize – control of a precious mineral or fossil fuel – can be huge, meaning that bandits expend super-normal energy in an effort to control the resource.

That is why many countries that have large endowments of natural resources contain multiple heavily armed militias, engaged in perpetual combat as they vie for control of resource revenues. An example is what befell Congo (now known as the Democratic Republic of the Congo) in the early 1960s, a crisis in which perhaps 100,000 people died.

The resulting deterioration in security is catastrophic for the economy: insecure property rights are a recipe for low investment in physical and human capital, and they greatly impair the economy’s ability to benefit from global trade and finance.

This problem is reinforced by the fact that many valuable natural resources, including oil, diamonds and gold, have productive processes that are capital-intensive and require only limited numbers of workers. This makes it easier for expropriators to quickly establish their own work teams, and limits the violent force necessary to generate revenues. In contrast, in countries such as Japan and Singapore that lack these types of resources, the easiest way to acquire wealth is to create it via cooperative and voluntary exchange with others. Trying to build PlayStations or operate banks by coercion would quickly result in an unprofitable and unsustainable enterprise.

Resource-rich countries such as Australia, Norway and the GCC countries have been fortunate to have had stable governments that emphasise property rights, halting would-be-bandits in their tracks. The resulting favourable security conditions have allowed for the attraction of foreign capital, and the investment of the natural resource wealth in improving the local economy.

Other, less fortunate countries have discovered natural resources during periods of poor governance, motivating groups to focus on violent expropriation as a way to improve their living standards, even if it comes at the expense of the economy taken as a whole. As the armed conflict increases in frequency, citizens will be left longing for the days before the discovery of natural resources, which is why the blessing of natural resources can sometimes turn into a curse.

Omar Al Ubaydli is programme director for international and geopolitical studies at the Bahrain Center for Strategic, International and Energy Studies, and an affiliated associate professor of economics at George Mason University. He welcomes economics questions from readers via email (omar@omar.ec) or tweet (@omareconomics).


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Updated: March 28, 2017 04:00 AM

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