Public Budget in Resource-Rich Economies

I. Introduction

When thinking about resource-rich economies and comparing them to their resource-poor counterparts, most non-economist will tend to believe that the abundance of resources must be a major advantage and that hence resource-rich countries are better off than resource-poor countries. However, this intuitive assumption is not entirely true as resource abundance tends to have a number of negative effects. Sometimes these negative effects even seem to predominate as numerous examples show. Nigeria, for instance, is a major oil exporter, receives billions of dollars in return for its oil, but has a population which is among the poorest in the world (Ziegler, 2010). Therefore, the discovery of natural resources, particularly oil, usually has a profound impact on economies, but also on the public budget as this article will show. The paper examines how public expenditures, revenue and debt in resource-rich economies changed in the past, how politicians and bureaucrats respond(ed) to resource abundance, and how an optimal budget rule for resource-rich economies should be designed. The possibilities to mitigate negative effects of oil price volatility and to enhance positive effects of resource revenues during periods of high oil prices are also discussed.

Section II looks at how resource-rich economies have coped with their resource endowments in the past. In order to do so, the resource curse theory is reviewed and positive examples of resource revenue management are presented. Section III analyses the behaviour of institutions in resource abundant economies. In section IV an attempt is made to design an optimal budget rule for resource-rich economies (partly) based on the findings in sections II and III. Section V concludes.

II. What can be learnt from history

Historically speaking, two main developments could be observed in resource-rich economies. A number of countries have done extremely well. However, “most mineral exporters, and in particular the oil exporters, have done far less well than resource-poor countries over the past few decades, particularly when considering the massive revenue gains to the oil exporting countries since 1973” (Eifert et al., 2002). This is because in many resource-rich economies the development of public expenditures, revenue and debt is characterised by a boom era which is followed by an era of economic decline, debt and “privatisation” (i.e. the end of public goods) (Oliveira, 2007). This development became known as the “resource curse” (Auty, 1993) or the “paradox of plenty” (Karl, 1997), i.e. the idea that a country’s resource endowment – especially with non-renewable resources – influences its economic growth. Many studies, for example by Sachs and Warner (1995), were able to show a link between resource endowments and a poor economic performance. The list of countries claimed not to have escaped the resource curse, for instance, includes Algeria, Nigeria, Congo, Saudi Arabia, Venezuela, and Ecuador (Matsen & Torvik, 2005). Interestingly, many of these are members of OPEC, the Organisation of the Petroleum Exporting Countries (OPEC, 2012).

Figure 1: Resource abundance and growth

illustration not visible in this excerpt

Source: Data used in Mehlum et al. (2006), Figure used in Torvik (2009).

Figure 1 shows the typical picture associated with the resource curse. Each point represents one country. The horizontal axis depicts the share of natural resource exports in GDP for each country and the vertical axis shows the average annual growth rate after the mid 1960s. The regression line indicates that on average there is a negative correlation between resource abundance and economic growth (Torvik, 2009, pp. 242) as claimed by the studies mentioned above. By just looking at the regression line one could assume that resource abundance automatically leads to lower economic growth. However, this is not the case as was shown by Torvik (2009) who argued that it is not the resource abundance resource-rich economies suffer from, but policy problems. Oliveira (2007) also emphasised this proposition and the importance of sustainable, long-term economic policies as a result of his analysis of the oil states along the Gulf of Guinea. Torvik’s proposition can be further strengthened by looking at long-term successful players in the group of resource-rich countries such as Australia and the US state of California (Rodrik, 2003), Norway (Sturm et. al., 2009) and Malaysia (Eifert et al., 2002). Thus, the resource curse appears to be more of a policy problem which induces lower economic growth in resource-rich economies due to bad fiscal policy choices by elites. Also, the resource curse tends to undermine governance and democracy (Alayli, 2005). However, it has to be said that researchers still struggle to agree on the overall effect of resource abundance in economies (Michaels, 2010).

The resource curse is hypothesized to happen for many different reasons. Sturm et al. (2009) listed four main explanations of this phenomenon: “the Dutch disease hypothesis; reduced incentives to develop the non-resource part of the economy; high volatility of resource revenues; and political economy effects of resource income, in particular with regard to institutional quality” (Sturm et al., 2009; p. 11).

(i) The Dutch disease hypothesis represents the traditional train of thought when discussing the resource curse (Auty & Gelb (1986), Auty (1994), Benjamin et al. (1989)). It is the combined influence of the following two effects:
1) a sharp rise in exports (such as oil) leads to an appreciation of the local currency
2) a booming resource sector tends to draw capital and labour away from other economic sectors, raising their production cost (i.e. making production other than in the resource sector unprofitable)
It is assumed that these two effects together lead to a decline in exports of agricultural and manufactured goods and inflate the cost of non-tradable goods (e.g. services) (Sturm et al., 2009). This means that the international competitiveness of an economy decreases and it becomes cheaper to import essential manufactured and agricultural products. Consequently, unemployment rises – particularly in the countryside where most agricultural workers are employed – and the ability to manufacture and grow crops deminishes (Sachs & Warner, 1995). Without work and a negative outlook with regards to future employment Oliveira (2007), for example, observed a general trend towards urbanisation. As Ziegler (2010) reports, a sudden increase in urbanisation without sufficient job opportunities in the cities is usually accompanied by a strong tendency of impoverishment of the poorer tiers of a population as cheap labour becomes abundant. In Nigeria, for instance, this development could be observed in Abuja and Lagos, two major cities with growing belts of townships. In addition, 58 per cent of Nigeria’s arable land stayed uncultivated in 2009. Another plausible scenario in a situation with high unemployment in oil states is an increased employment of the population in the state sector (such as in many of the Arabian oil states where the natural population is mostly state-employed (Gelb, 2010)). Empirical research shows that not all oil states suffered from Dutch disease as the shift of labour and capital towards economic activities aimed at resource extraction was not as significant as assumed by many economists (period: 1971-1983, Sturm et al., 2009)
(ii) Another possible explanation for the resource curse are reduced incentives to develop the non-resource part of the economy. Resource abundance might lead to a weaker focus on the development of human resources (Birdsall & Jasperson, 1997). This can partly be supported by the fact that most oil companies – especially the multi-nationals – employ mostly foreign workers on their production plants as the local population lacks the skills required to work in the oil business (Ziegler, 2010). Furthermore, the accumulation of private capital might suffer and not be developed (Buffie, 1993; Stevenson, 2003). Economic development, however, requires the accumulation of private capital based on the decentralized decisions of individuals, as Alayli (2005) pointed out. In addition, “the concentration of resource revenues on the public sector could (…) delay difficult decisions on economic reforms” (Sturm et al., 2009) and disturb economic development which again might reduce “investment efficiency, cumulate economic distortions and retard diversification” (Sturm et al., 2009). All these effects are rather problematic as they do not decrease countries’ dependence on natural resource revenues
(iii) Generally, the public expenditure and revenues of numerous resource-rich economies are more volatile because the countries’ economic performance depends on the proceeds they receive for selling their natural resources in the world market (Hinojosa et al., 2010). As such, they are highly vulnerable to price changes as several studies have shown (e.g. Lane, 2003; Afonso & Furceri, 2008). As a result of income volatility, some economies experienced a phase of economic decline (as mentioned above), for they were used to a particular stream of income to finance their state apparatus, public goods, etc. As soon as the stream of income diminished, the countries had to either reduce their public spending (unlikely) or run up debts (usual scenario). Oliveira (2007) suggests that these debts are the “most crippling and lasting element of the post-boom crisis”. The individual government’s inability to manage surpluses in the boom era increases the impact of changes in volatility (Auty, 2001). Examples for such mismanagement are pro-cyclical fiscal policies or the unproductive use of public funds instead of taking the necessary measures to save and stabilise revenues (see e.g. Eifert et al., 2002)
(iv) Finally, there is a school of thought focusing on political economy effects of resource abundance as an explanation of the resource curse. Easterly & Levine (1997) and Karl (1997) have shown that “natural resource rents can be a source of conflict, political instability, corruption, weak institutions, inequitable distribution of wealth and policy failure” (Sturm et al., 2009). Furthermore, it appears that countries with a low level of trade openness are affected more severely by the resource curse than more open countries. Also, bad trade policies are highly correlated with bad fiscal policies (Ploeg & Aretzki, 2008). On the one hand, there is a significant negative indirect effect of natural resources and the quality of institutions (Sala-i-Martin & Subramanian, 2003), on the other hand, institutional quality impacts economic growth in resource-rich economies (Mehlum et al. (2006)). Resource abundance tends to have a positive effect on countries with an early industrialisation and strong institutions (Acemoglu et al., 2001) and a negative effect among countries with weak institutions. Additionally, the location of the resource source (onshore or offshore) seems to have some effect on how well a political economy deals with its resource abundance. Offshore operations can be easier protected, run relatively independently from the mainland, and require more sophisticated knowledge for extraction due to the offshore terrain. These three factors may lead to more political stability and the development and aggregation of unique extraction know-how (e.g. as in Norway) (Torvik, 2009).

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