Struggling with the Resource Curse

April 6, 2011

By Nina Merchant-Vega

The “resource curse” in development is well known. Countries endowed with valuable natural resources –most notably oil, natural gas, minerals, and diamonds – often also suffer from poor governance, high poverty, and conflict. And, as recent events in the Middle East have reminded us, such countries are frequently authoritarian and highly repressive.

Litres of petrol for sale on the roadside in Timor-Leste. While Timor contains less than 1 percent of the world's known oil reserves, this still translates into significant potential development revenue for the small nation. Photo by Martin Wurt.

The economic and political dynamics of the resource curse are complex and intertwined. From a purely economic perspective, many resource-exporting countries suffer from what is known as “Dutch Disease.” In resource-exporting economies, other tradable sectors – typically manufacturing – suffer from the real appreciation of the national currency due to export earnings from natural resources flooding into the country. This makes other exports from those countries more expensive and therefore less competitive on world markets. Indeed, it is not atypical to find very resource-rich countries with virtually no manufacturing sector.

Similarly, political competition over rents in resource-dependent countries is often fraught. In states where governance is poor and institutions are weak, traditional ruling elites fight for control of resource wealth. Sometimes an equilibrium is reached in which one strongman comes to power and rules decisively, as was the case in most Middle East and North African countries until recently. And, although overt conflict is generally avoided, such states often suffer from massive corruption, political violence, and systemic repression. In other instances, overt conflict between different factions – sometimes fueled by the resources themselves (such as some of Sub-Saharan Africa’s post-colonial civil wars that were fueled by diamonds) – can drag on for years and even decades.

Policy Implications: The Example of Botswana

Resource revenues, properly invested in social and economic infrastructure, can help produce economic prosperity. Botswana – a poor, small, land-locked southern African country that also happens to be the 18th largest diamond exporter in the world – provides an apt example. For all intents and purposes, Botswana should have gone down the typical “resource curse” road. But it did not. Instead, the country was able to translate its resource wealth into growth and development.

So, what did Botswana do differently? Botswana’s government guarantees political rights and ensures that citizens have the power to monitor and replace those in power. Similarly, government management of resource wealth is sound and accountable. Botswana developed a Sustainable Budget Index (SBI), under which all resource revenue goes to finance investment expenditure and recurrent health and education spending. Botswana also invests a portion of its resource wealth in a Sovereign Wealth Fund, which preserves a portion of the income from diamond exports for future generations. As a result, Botswana continually ranks well on global and regional measures of governance.

Such sound policies have translated into big gains for the country. Botswana is among the fastest-growing countries in the world, registering a 9 percent annual growth rate from independence in 1966 to 1999. And, although Botswana still faces many social and economic problems, poverty rates have been steadily declining since independence, signaling that the country’s growth is indeed becoming more inclusive.

Implications for Asia’s Resource-Rich Economies

Botswana can provide some key insights for Asia. While Asia has many larger resource-rich economies, such as China, Indonesia, and India, like the United States and Brazil, the size and diversity of these economies helps to insulate them from many of the typical problems of the resource curse. It is Asia’s smaller resource-rich countries – particularly Mongolia and Timor-Leste – that are more vulnerable.

Mongolia sits on vast mineral wealth. From 2004 to 2008, high mineral prices translated into large government revenues. However, like many resource-dependent countries, Mongolia has struggled to convert the wealth into development results. Revenue windfalls were quickly converted into across-the-board cash transfers and increased civil service salaries. These rapid increases exceeded the economy’s absorptive capacity, contributing to high inflation. In addition, the country recently abolished its Windfall Profits Tax on resource revenue, which will put considerable pressure on the country’s still-expanding budget.

In-short, Mongolia has a highly expansionary short-term fiscal policy fueled primarily by resource revenue. This expansion is fueling inflation and exchange rate appreciation, which will ultimately result in lowering purchasing power for ordinary citizens. There is already evidence that “Dutch Disease” has taken hold. For example, 71 percent of foreign direct investment (FDI) went to the mining sector, whereas 1 percent went to the communications and IT sectors. Also, in 2010, the Mongolian tugrug was the strongest currency against the USD.

In order to avoid macro-economic instability, the government needs to better adhere to good resource-management practices. Although the government has increased its investment expenditures and passed a Fiscal Stability Law, nearly half the current budget will go to direct cash transfers. While such transfers have benefited low-income populations, widespread transfers contribute to inflation.

Timor-Leste faces similar problems. While Timor contains less than 1 percent of the world’s known oil reserves, this still translates into significant potential development revenue for the small nation. Like Botswana, Timor has a Petroleum Fund that is supposed to preserve its oil wealth for future generations. Under the Petroleum Law governing the Fund, policy-makers cannot draw down more than the Estimated Sustainable Income (ESI) – calculated from the price of oil and other factors – in any given year without parliamentary approval. The ESI provision is supposed to ensure money is spent wisely and guaranteed for future generations. However, the government drew down more than the ESI in 2009 and 2010. The proposed 2011 budget does the same and drawn legal challenges from the opposition.

The primary problem is that there is no check on parliamentary authority to override the ESI provision. Since the same government that proposes and passes budgets is able to simply vote to override the ESI, it is not clear the mechanism is sufficient to rein in spending from the Petroleum Fund. In addition, possible revisions to the Petroleum Law are now being discussed, including increasing the withdrawal limits on the ESI and allowing the government to withdraw money from the fund for “temporary appropriations” without parliamentary approval if the budget is not approved on time. Such changes would further weaken the law.

There is no “magic bullet” solution to deal with the resource curse. At present, incentives in Mongolia and Timor-Leste are skewed toward short-term political and financial gains. Ultimately, policy-makers must have the right incentives to be responsive to longer-term social and economic investment. The process to bring about such change is by no means clear or easy. Once entrenched, such political arrangements become powerful and self-perpetuating. While the emphasis has been on technical solutions (establishing a fund), not enough attention has been paid to understanding and countering the political forces that manipulate resource distribution for short-term gain. More attention must be paid to these forces if future generations are to benefit from the “resource blessing” rather than suffer from the resource curse.

Nina Merchant-Vega is The Asia Foundation’s assistant director for the Economic Reform and Development program. She can be reached at [email protected].

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