The%20Natural%20Resource%20Curse%20and%20How%20to%20Avoid%20It%20Jeffrey%20Frankel%20Harpel%20Professor%20of%20Capital%20Formation%20

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The Natural Resource Curse and How to Avoid
ItJeffrey FrankelHarpel Professor of Capital
Formation Growth

• IMF Institute for Capacity Development (formerly
  IMF Institute) July 27, 2012

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The Natural Resource CursePart 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).

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• 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.

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• 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.

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Growth falls with fuel mineral exports
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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.

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• 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.

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• 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.

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5 Possible Natural Resource Curse Channels

1. Volatility
2. Crowding-out of manufacturing
3. Autocratic Institutions
4. Anarchic Institutions
5. Procyclicality including
6. Procyclical capital flows
7. Procyclical monetary policy
8. Procyclical fiscal policy.

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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

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The trend since 1960 has been up
A.Saiki, Dutch Nat.Bk.
Nominal prices2010100
Real prices nominal in 2000
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• (1) Volatility in global commodity prices
  arises because supply demand are inelastic in
  the short run.

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Commodity prices have been especially volatile
over the last decade
Source UNCTAD
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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.
• gt 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.

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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.
• gt Mere hewers of wood and drawers of water
  remain forever poor (Deuteronomy 2911) 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

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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 way
  government can finance itself.

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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 Middle Eastern oil
exporters well. E.g., Iran. Mahdavi
(1970), Skocpol (1982, p. 269), and Smith (2007).

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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.

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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.
  

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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.

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4. Anarchic institutions

1. Unsustainably rapid depletion of resources
2. Unenforceable property rights
3. Civil war

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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).

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The example of Nauruphosphate mining
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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.

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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-rainf
orestE28099s-madre-de-dios-20021
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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.

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(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

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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

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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.

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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.

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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.
• the dichotomy extends also to effects on
  sovereign bond spreads.
• But many developing countries avoided borrowing
  in the 2003-11 boom.

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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.

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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).
• Thats backwards. (E.g., oil importers in
  2008.)
• Should appreciate when export commodity price
  goes up.

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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.
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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.

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• 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.

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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).
• (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 its unsalvageable..
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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.
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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

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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
policyNegative correlation of G GDP.
countercyclical
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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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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).

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• 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?

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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 gt
• expected rate of price increase interest rate.

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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.
  

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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).