The Natural Resource The Natural Resource Curse and How to Avoid Curse and How to Avoid

ItItJeffrey FrankelJeffrey Frankel

Harpel Professor of Capital Formation & GrowthHarpel Professor of Capital Formation & Growth

IMF Institute for Capacity Development (formerly IMF IMF Institute for Capacity Development (formerly IMF Institute)Institute)

July 27, 2012 July 27, 2012

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The NaturalThe Natural ResourceResource

CurseCursePart I: ChannelsPart I: Channels

Some seminal references:Some seminal references: AutyAuty (1990, 2001, 2007) (1990, 2001, 2007)

Sachs & WarnerSachs & Warner (1995, 2001), (1995, 2001),

By now there is a large body of By now there is a large body of research, research, which I have surveyed which I have surveyed (2011, 2012a, b).(2011, 2012a, b).

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 Some studies find a negative effect of oil in particularin particular, on economic performance:, on economic performance: including Kaldor, Karl & Said (2007); Ross (2001); including Kaldor, Karl & Said (2007); Ross (2001);

Sala-i-Martin Sala-i-Martin && Subramanian (2003); Subramanian (2003); and and Smith (2004).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.

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Growth falls with fuelGrowth falls with fuel && mineral mineral exportsexports

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Are natural resources Are natural resources necessarilynecessarily bad? bad?

Commodity wealth needCommodity wealth need not necessarily lead not necessarily lead to inferior economic or political development. to inferior economic or political development.

Rather, it is a double-edged sword, Rather, it is a double-edged sword, with both benefits and dangers. with both benefits and dangers. It can be used for ill as easily as for good.It can be used for ill as easily as for good.

The priority should be on identifying ways The priority should be on identifying ways

to sidestep the pitfalls that haveto sidestep the pitfalls that have afflictedafflicted commoditycommodity producers in the past, producers in the past, to find the path of success. to find the path of success.

No, of course not.No, of course not.

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Some developing countries have avoided Some developing countries have avoided the pitfalls of commodity wealth.the pitfalls of commodity wealth.

E.g., Chile (copper)E.g., Chile (copper)

Botswana (diamonds)Botswana (diamonds)

Some of their innovations are worth emulating.Some of their innovations are worth emulating.

The 2The 2ndnd half of the lecture will offer some policies half of the lecture will offer some policies & institutional innovations to avoid the curse: & institutional innovations to avoid the curse:

especially ways of managing price volatility.especially ways of managing price volatility. Some lessons apply to commodity Some lessons apply to commodity importers importers too.too. Including lessons of policies to avoid.Including lessons of policies to avoid.

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But, 1But, 1stst: How could abundance : How could abundance of commodity wealth be a curse? of commodity wealth be a curse?

What is the mechanism What is the mechanism

for this counter-intuitive relationship? for this counter-intuitive relationship?

At least 5 categories of explanations.At least 5 categories of explanations.

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1.1. Volatility Volatility

2.2. Crowding-outCrowding-out of of manufacturingmanufacturing

3.3. Autocratic InstitutionsAutocratic Institutions

4.4. Anarchic InstitutionsAnarchic Institutions

5.5. ProcyclicalityProcyclicality includingincluding

1.1. Procyclical capital flowsProcyclical capital flows

2.2. Procyclical monetary policyProcyclical monetary policy

3.3. Procyclical fiscal policy.Procyclical fiscal policy.

5 Possible Natural Resource Curse Channels

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

0

20

40

60

80

100

120

140

160

180

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

in prices of 2010 In prices of 2000*

Commodity prices: all commoditiesIndices

*) Deflated by US consumer price index.Source: HWWA, Datastream.

Nominal prices2010=100

Real prices * = nominal in 2000

A.Saiki, Dutch Nat.Bk.

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

Commodity prices have been especially volatile over the last

decade

Source: UNCTAD

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Effects of VolatilityEffects of Volatility

Volatility Volatility per seper se can be bad for economic growth. can be bad for economic growth. Hausmann & Rigobon Hausmann & Rigobon (2003),(2003), Blattman, Hwang, & Williamson Blattman, Hwang, & Williamson (2007),(2007),

and Poelhekke & van der Ploeg and Poelhekke & van der Ploeg (2007).(2007).

Risk inhibits private investment.Risk inhibits private investment.

Cyclical shifts of resources back & forth across Cyclical shifts of resources back & forth across sectors may incur needless transaction costs.sectors may incur needless transaction costs.

=> role for government intervention?=> role for government intervention? On the one hand, the private sector dislikes risk as On the one hand, the private sector dislikes risk as

much as government does & takes steps to mitigate it.much as government does & takes steps to mitigate it. On the other hand the government On the other hand the government

cannot entirely ignore the issue of volatility; cannot entirely ignore the issue of volatility; e.g., exchange rate policy.e.g., exchange rate policy.

2. Natural resources may 2. Natural resources may crowd outcrowd out

manufacturingmanufacturing,, and manufacturing could be the sector and manufacturing could be the sector

that experiences learning-by-doing that experiences learning-by-doing or dynamic productivity gains from spillover.or dynamic productivity gains from spillover. MatsuyamaMatsuyama (1992), (1992), vanvan WijnbergenWijnbergen (1984) (1984) and and SachsSachs && WarnerWarner (1995). (1995).

So commodities could in theory be a dead-end sector.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 My own view: a country need not repress the commoditycommodity sector to develop the manufacturingsector to develop the manufacturing sector.sector. It can foster growth in both sectors.It can foster growth in both sectors.

E.g. Canada, Australia, Norway… Now Malaysia, Chile, Brazil…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 Countries where physical command of

natural resources by government or a natural resources by government or a hereditary elite automatically confers hereditary elite automatically confers wealth on the holders wealth on the holders

are likely to become rent-seeking societies; are likely to become rent-seeking societies; and and are less likely to develop the institutions are less likely to develop the institutions

conducive to economic development,conducive to economic development, e.g., decentralizatione.g., decentralization & & economiceconomic incentives; incentives; as compared to countries where moderate as compared to countries where moderate

taxation of a thriving market economy is the taxation of a thriving market economy is the only way government can finance itself.only way government can finance itself.

Econometric findings that oil

and 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 The theory is thought to fit Middle Eastern oil exporters well.exporters well.

E.g., Iran. Mahdavi (1970), Skocpol (1982E.g., Iran. Mahdavi (1970), Skocpol (1982, p. 269, p. 269), and Smith ), and Smith (2007). (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 (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 institutions4. Anarchic institutions

1.1. Unsustainably rapid Unsustainably rapid depletion of resources depletion of resources

2.2. Unenforceable Unenforceable property rightsproperty rights

3.3. Civil warCivil war

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4.1 4.1 Unsustainably Unsustainably rapid depletion rapid depletion

When exhaustible resources When exhaustible resources are in fact exhausted, are in fact exhausted, the country may be left with nothing.the country may be left with nothing.

Three concerns:Three concerns: Protection of Protection of environmental qualityenvironmental quality..

A motivation A motivation forfor a a strategy strategy of of economic economic diversificationdiversification..

The need to save for the day of depletion The need to save for the day of depletion Invest rents from exhaustible resources in other assets. Invest rents from exhaustible resources in other assets.

Hartwick (1977) and Solow (1986).

The example of Nauruphosphate mining

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4.2 Unenforceable property 4.2 Unenforceable property rightsrights

Depletion would be much less of a problem Depletion would be much less of a problem if full property rights could be enforced, if full property rights could be enforced, thereby giving the owners incentive thereby giving the owners incentive

to conserve the resource in question.to conserve the resource in question.

But often this is not possibleBut often this is not possible especially under frontier conditions.especially under frontier conditions.

Overfishing, overgrazing, & over-logging are classic Overfishing, overgrazing, & over-logging are classic examples of the “tragedy of the commons.” examples of the “tragedy of the commons.”

Individual fisherman, ranchers, loggers, or miners, Individual fisherman, ranchers, loggers, or miners, have no incentive to restrain themselves, while the have no incentive to restrain themselves, while the fisheries, pastureland or forests are collectively fisheries, pastureland or forests are collectively depleted.depleted.

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

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4.3 War4.3 War Where a valuable resource such as oil or Where a valuable resource such as oil or

diamonds diamonds is there for the taking, factions will likely fight is there for the taking, factions will likely fight over it. over it.

Oil & minerals are correlated with civil war.Oil & minerals are correlated with civil war. Fearon & Laitin Fearon & Laitin (2003),(2003), Collier Collier & & Hoeffler Hoeffler (2004),(2004),

Humphreys Humphreys (2005) (2005) and Collier and Collier (2007).(2007).

Chronic conflict in places Chronic conflict in places such as Sudan comes to mind.such as Sudan comes to mind.

Civil war is, in turn, very bad Civil war is, in turn, very bad for economic development.for economic development.

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(5) Procyclicality(5) Procyclicality The The Dutch DiseaseDutch Disease describes unwanted describes unwanted

side-effects of a commodity boom.side-effects of a commodity boom.

Developing countries are Developing countries are historically pronehistorically prone to to procyclicality,procyclicality, especially commodity producers.especially commodity producers.

ProcyclicalityProcyclicality in: in: Capital inflows; Monetary policy;Capital inflows; Monetary policy; Real exchangeReal exchange rate; Nontraded Goodsrate; Nontraded Goods Fiscal PolicyFiscal Policy

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The Dutch Disease: The Dutch Disease: 5 side-effects of a commodity 5 side-effects of a commodity

boomboom

1) A real appreciation in the 1) A real appreciation in the currency currency

2) A rise in government spending 2) A rise in government spending 3) A rise in nontraded goods prices 3) A rise in nontraded goods prices

4) A resultant shift of production 4) A resultant shift of production out of manufactured goods out of manufactured goods

5) Sometimes a current account 5) Sometimes a current account deficitdeficit

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The Dutch Disease: The 5 effects elaboratedThe Dutch Disease: The 5 effects elaborated

1) Real appreciation in the 1) Real appreciation in the currencycurrency

taking the form of nominal currency taking the form of nominal currency appreciation appreciation if the exchange rate floatsif the exchange rate floats

or the form of money inflows, credit or the form of money inflows, credit & inflation if the exchange rate is fixed;& inflation if the exchange rate is fixed;

2) A rise in government spending 2) A rise in government spending in response to availability of tax receipts or royalties.in response to availability of tax receipts or royalties.

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The Dutch Disease: 5 side-effects of a commodity boomThe Dutch Disease: 5 side-effects of a commodity boom

3) An increase in nontraded goods 3) An increase in nontraded goods pricesprices relative to internationally traded goodsrelative to internationally traded goods

4) A resultant shift out of 4) A resultant shift out of non-commodity traded goods,non-commodity traded goods,

esp. manufactures,esp. manufactures,

pulled by the more pulled by the more attractive returns attractive returns in the export commodity in the export commodity and in non-traded goodsand in non-traded goods..

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The Dutch The Dutch Disease: 5 side-effects of a commodity boomDisease: 5 side-effects of a commodity boom

5) A current account deficit,5) A current account deficit, as booming countries attract capital flows,as booming countries attract capital flows,

thereby incurring international debt that thereby incurring international debt that is hard to service when the boom ends.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 But many developing countries avoided borrowing in the 2003-11 boomboom..

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.

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 taking the form of nominal currency

appreciationappreciation for floating-rate commodity exporters, for floating-rate commodity exporters,

Colombia, Kazakhstan, Russia, S.Africa, Chile, Brazil…. Colombia, Kazakhstan, Russia, S.Africa, Chile, Brazil….

or the form of money inflows & inflationor the form of money inflows & inflation for fixed-rate commodity exporters,for fixed-rate commodity exporters,

Saudi Arabia & UAE….Saudi Arabia & UAE….OK. But real appreciation adds to boom in NTGs.

Procyclical fiscal policy

Fiscal policy has historically tended Fiscal policy has historically tended to be procyclical in developing countries to be procyclical in developing countries especially among commodity exporters:especially among commodity exporters: Cuddington (1989), Tornell & Lane (1999), Kaminsky, Cuddington (1989), Tornell & Lane (1999), Kaminsky,

Reinhart & Vegh (2004), Talvi & Végh (2005), Alesina, Reinhart & Vegh (2004), Talvi & Végh (2005), Alesina, Campante & TabelliniCampante & Tabellini (2008), Mendoza & Oviedo (2006), (2008), Mendoza & Oviedo (2006), Ilzetski & Vegh (2008), Medas & Zakharova (2009), Gavin & Ilzetski & Vegh (2008), Medas & Zakharova (2009), Gavin & Perotti (1997).Perotti (1997).

Correlation of income & spending mostly Correlation of income & spending mostly positive –positive –

particularly in comparison with industrialized countries.particularly in comparison with industrialized countries.

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The procyclicality of fiscal policyThe procyclicality of fiscal policy

A reason for procyclical public A reason for procyclical public spending: spending: receipts from taxesreceipts from taxes && royalties rise in royalties rise in booms.booms.

The government cannot resist the temptation The government cannot resist the temptation to increase spending proportionately, or to increase spending proportionately, or more.more.

Then it is forced to contract in recessions, Then it is forced to contract in recessions, thereby exacerbating the swings. thereby exacerbating the swings.

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Two budget items account for much Two budget items account for much

of the spending from oil booms:of the spending from oil booms: (i) Investment projects.(i) Investment projects.

Investment in practice may be Investment in practice may be “white“white elephant” projects,elephant” projects,

which are stranded without funds which are stranded without funds for completion or maintenance for completion or maintenance when the oil price goes back down.when the oil price goes back down.

Gelb Gelb (1986).(1986).

(ii) The government wage bill.(ii) The government wage bill. Oil windfalls are often spent on public sector Oil windfalls are often spent on public sector

wages. wages. Medas & Zakharova Medas & Zakharova (2009) (2009)

Arezki & IsmailArezki & Ismail (2010)(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..”

Correlations between Gov.t Spending & GDP1960-1999p

rocyclic

al }

G always used to be pro-cyclical for most developing countries.

countercyclic

al

Adapted from Kaminsky, Reinhart & Vegh (2004)

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Procyclicality has been especially strong Procyclicality has been especially strong in commodity-exporting countries.in commodity-exporting countries.

An important development -- An important development -- some developing countries, including some developing countries, including commodity producers, were able to break commodity producers, were able to break the historic pattern in the most recent the historic pattern in the most recent decade:decade: taking advantage of the boom of 2002-2008taking advantage of the boom of 2002-2008

to run budget surpluses & build reserves,to run budget surpluses & build reserves,

thereby earning the ability to expand thereby earning the ability to expand fiscally in the 2008-09 crisis.fiscally in the 2008-09 crisis.

Chile is the outstanding model. Chile is the outstanding model. Also Botswana, China, Indonesia, Korea…Also Botswana, China, Indonesia, Korea…

The procyclicality of fiscal policy,The procyclicality of fiscal policy, contcont..

Correlations between Government spending & GDP 2000-2009

In the last decade, about 1/3 developing countries

switched to countercyclical fiscal policy:Negative correlation of G & GDP.

Frankel, Vegh & Vuletin (2012)

procyclic

al

countercyclic

al

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).

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 (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.

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).