Natural Resources: Curse or Blessing?

Pumping wealth, or poison?

Strike riches buried below ground and — weep. That appears to be the fate of many resource-rich countries. This seems counter-intuitive; after all, a windfall is a windfall, so what should be so detrimental about it? But it also seems to be common-knowledge: everyone has heard of the Dutch disease, blood diamonds, the oil curse and so on. What is less clear is why that should be so, and what really helps countries to benefit from their natural riches.

It is only fitting that a Dutch scholar should tackle the issue. Rick van der Ploeg, of Oxford University and head of the Public Finance Area at the CESifo Research Network, examines in depth the issue of when natural resources become a curse or a blessing in his latest CESifo Working Paper.

He starts by highlighting that empirical evidence actually points both ways: there are both success stories and utter fiascos when it comes to economic performance vis-à-vis availability of natural resources. Or lack thereof: Singapore, Hong Kong, Switzerland, South Korea, Luxembourg and Japan, to name but a few, have succeeded beyond any expectations despite a near total lack of natural riches. Singapore, for instance, must even import potable water and the sand necessary to mix its concrete, and yet its GDP per capita is more than twice as high as Saudi Arabia’s.

Another noteworthy example is the Netherlands. In the seventeenth century, this resource-poor country outpaced Spain even though the latter obtained much gold and silver from its colonies in the New World.

That is the key question: why are some resource-rich economies successful, while others perform badly despite their immense natural wealth? The answers should also shed light on why resource-poor countries such as the ones mentioned above can nonetheless perform so well.

Some Crack It, Others Just Crack
The most dramatic example of a badly-performing resource-rich economy is perhaps Nigeria. Its per capita oil revenues increased tenfold between 1965 and 2000, but the country still ranks among the 15 poorest in the world, its income per capita practically unchanged since independence in 1960. Nearly 70% of its people live on less than US$1 per day. Two-thirds of manufacturing capacity simply goes to waste.

Other oil exporters, such as Iran, Venezuela, Libya and Kuwait, have experienced economic deterioration during the last few decades. Even the OPEC as a whole saw a decline in GNP per capita.

But not all is negative. Botswana, for one, has beaten the curse that could have resulted from the fact that it derives 40% of its GDP from diamonds. It has enjoyed the world’s highest growth rate since 1965, and its GDP per capita is at least ten times that of Nigeria. Norway has achieved remarkable economic development, its manufacturing industry thriving despite the phenomenal growth of its oil exports. It is the world’s third-largest crude exporter after Saudi Arabia and Russia.

The United Arab Emirates have used their extraordinary fossil fuel wealth to modernise infrastructure, improve education and healthcare, create jobs and set up a generous welfare system. Chile, which gets most of its foreign income from copper exports, stashes the excess cash in an overseas fund and has achieved nearly developed status in the past couple of decades.

The US, in turn, profited mightily from its mineral wealth. It was the leading mineral economy in the very period that the country became the world leader in manufacturing. In 1913, it was the world’s dominant producer of virtually every major industrial mineral, even though other countries initially seemed to have more mineral reserves.

So, if one preliminary conclusion may be derived from all this, is that successful resource-based development does not depend primarily on geological endowment, as Mr van der Ploeg elegantly puts it.

To see what may really explain the resource paradox, Mr van der Ploeg examines eight popular hypotheses, and adds two more for good measure.

The Eight Hypotheses
1. Dutch Disease. Coined in the late 1970s to describe the decline in manufacturing experienced by the Netherlands after the discovery of a large gas deposit, it states that a resource bonanza induces appreciation of the real exchange rate, contraction of the traded sector and expansion of the non-traded sectors, leading to de-industrialisation.

A study conducted on the basis of data for 135 countries for the period 1975-2007 indicates that the response to a resource windfall is to save about 30 percent, decrease non-resource exports by 35-70 percent, and increase non-resource imports by up to 35%. Another study using detailed data comes to a 10% oil windfall being associated with a 3.4% average fall in value added across manufacturing, but less so in countries that have restrictions on capital flows and for sectors that are more capital-intensive.

2. The sputtering traded-sector engine. If the traded sector is the engine of growth, a resource bonanza will lead to a temporary fall in growth. This can explain why, although a declining trading sector is actually the appropriate market response to a resource windfall, since the optimal thing is to specialise in one’s comparative advantage, such windfalls are nonetheless perceived as a problem.

Empirical evidence shows that resource-rich countries grew on average about one percentage point less over the 1970-89 period, even in countries with a long period in which their economy was rated as open and whose citizens accept the rule of law. This is what has become known as the resource curse.

3. Institutions. Resource wealth may worsen the quality of institutions, since it allows governments to pacify dissent, buy off political adversaries, avoid accountability and resist modernisation. It also prevents redistribution of political power towards the middle classes and hinders the adoption of growth-promoting policies. Resource riches also raise the value of being in power. All this seems to be at the heart of the Nigerian lack of economic performance.

Conversely, empirical evidence shows that good institutions can turn the curse into a blessing. Countries with a high-enough index of institutional quality experience no curse, as demonstrated by the US, Canada, Norway, the Netherlands, New Zealand and Australia.

4. The presidential effect. A cross-country sample of 90 countries suggests that the resource curse occurs in presidential, not parliamentary democracies. The former are less accountable and less representative, and thus offer more scope for rent extraction. The nature of the constitutional system is empirically more important that democratic rule itself for the link between resource dependence and growth. Needless to say, the more non-democratic, the worse the outcome.

5. Corruption. Resource dependence elicits corruption and rent-seeking via protection, exclusive licenses and other unsavoury ways to capture wealth and political power. Panel evidence covering 99 countries during 1980-2004 suggests that natural resources only induce corruption in countries that have endured a non-democratic regime for more than 60% of the years since 1956, controlling for income, time-varying common shocks, regional fixed effects and some other covariates. Democratization may thus be a powerful instrument to curb corruption in resource-rich countries.

A study suggests that the combination of high natural resource rents and open democratic systems retards growth, unless there are sufficient checks and balances, which is not the case in many new resource-rich democracies. Another study using data on Brazilian municipalities finds that a municipal windfall of 10% increases corruption by 17-24 percent, raises the chances of the incumbent holding on to office by 7 percent, and shrinks the fraction of its opponents holding a college degree by 7 percent.

6. Volatility. Historical evidence for the period 1870-1939 suggests that volatility harms growth for the commodity-dependent ‘periphery’ nations rather than for Europe or the US. Resource-rich countries also suffer from poorly developed financial systems and from financial remoteness, so that they are likely to experience bigger macroeconomic volatility.

This is particularly so for point-based resources (oil, diamonds) and in landlocked, ethnically polarized economies with weak financial institutions, current-account restrictions and high capital account mobility. The indirect negative effect of resource exports on growth via the volatility channel outweighs any direct positive effect of resources on growth. Volatility seems the quintessence of the resource curse, but is offset somewhat in countries with a high degree of financial development.

7. Rent-seeking and armed conflict. Resource revenues are prone to rent-seeking and wastage, made easier if property rights are badly defined, markets are imperfect and legal systems deficient. The ‘voracity effect’ causes a drag on growth as seen after the oil windfalls in Nigeria, Venezuela and Mexico, because it reduces the capital left for investment in the formal sector.

Production and resource income have an opposing effect on armed conflict. Higher production income makes warfare less attractive and conflict less likely to occur, whereas higher resource income makes warfare more attractive as there is more to fight over. Indeed, cross-country evidence suggests a negative relationship between shocks in the growth of production income and the risk of civil war and a positive relationship between resource income and conflict. For instance, a country with no resources has a probability of civil conflict of merely 0.5 percent, but a country with a share of natural resources in GDP of a quarter has a probability of 23 percent.

Empirical evidence suggests that the resource curse is more severe in countries that have many ethnic or religious fractions and many languages. We should therefore see more conflict in ethnically heterogeneous societies such as Rwanda, Sudan, Indonesia, and Afghanistan, among others, and less violent resource conflicts in homogenous societies like Botswana.

8. Unwise and unsustainable policies. In general, a sudden resource bonanza tends to erode the critical faculties of politicians and induce a false sense of security. Politicians are likely to lose sight of growth-promoting policies, free trade and ‘value for money’ management. After the discovery of gas in the Netherlands, successive Dutch governments responded irresponsibly, expanding public employment, making benefits more generous, raising the minimum wage and introducing protective labour market legislation. It took more than twenty years to put the Dutch welfare state on a financially sustainable footing again.

And Two Further Hypotheses
Anticipation of better times. Resource-rich countries borrow in anticipation of higher world prices for resources and improvements in extraction technology in the future.

Rapacious extraction. In absence of government intervention, conflict among rival factions induces excessive resource extraction and investment, and negative genuine saving when there is wasteful rent-seeking, investment in “white elephants” and short-sighted politicians.

What should resource-rich countries then do? For starters, they should invest their natural resource rents into reproducible assets such as physical capital, human capital, infrastructure or foreign assets. In well-developed economies it may be optimal to put natural resource revenues in a sovereign wealth fund, as Norway and Chile do. Less developed countries would do well to use the windfall to pay off debt and lower interest rates, in order to boost private and domestic capital accumulation and speed up the process of economic development.

An interesting option is to change the constitution to guarantee that resource revenues are handed to the public. The government has to subsequently tax its citizens to finance its spending programmes. Most important is for countries to learn from US history and adopt an optimistic, forward-looking approach to technological innovation in resource exploration and the search for new reserves.

Mr van der Ploeg also proposes areas for further research, such as why the resource curse seems to be a phenomenon of the past four decades or so. Before that, countries appeared better able to harness their new-found wealth to boost their economic development. In addition, the insights of contract theory should be put to work in devising better incentive-compatible contracts between governments and exploration companies.

Frederick van der Ploeg: Natural Resources: Curse of Blessing?, CESifo Working Paper No. 3125

• Other CESifo Working Papers by Frederick van der Ploeg
• Other CESifo Working Papers dealing with natural resources
• Other CESifo Working Papers dealing with institutions
• Other CESifo Working Papers dealing with corruption
• CESifo Working Papers published in the past three months