Chapter 3. Country Experiences with Managing Natural Resource Windfalls

Niko Hobdari, Eric Le Borgne, Chonira Aturupane, Koba Gvenetadze, John Wakeman-Linn, and Stephan Danninger
Published Date:
April 2004
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It is ironic that what should be a blessing has often turned into a curse. A natural resource boom, effectively managed, should provide a country with the resources to finance essential economic reforms, including a cushion for the vulnerable against the impact of those reforms. Unfortunately, the experiences of natural-resource-abundant countries show that this has not typically been the case. In general, rather than using natural resource revenue to finance the development of other aspects of the economy, authorities have usually tended to act based on optimistic assumptions about the size and extent of natural resource booms, and to use these optimistically forecast revenues to finance consumption.

Decisions regarding the spending of natural resource revenues should be based on the likely duration of the resource boom, the expected income (subject to price assumptions), extraction costs, and the time horizon during which exhaustible resources may be depleted. In light of the uncertainties associated with these estimates and the unpredictable path of the terms of trade, it would be logical to take a cautious stand and forgo present consumption in favor of security against unfavorable developments in the future. However, the experience of resource boom countries shows that, generally, authorities tend to act on optimistic assumptions. Below are examples of policies that have been common in both developed and developing countries managing windfalls from natural resource booms during the 1970s and 1980s, and the implications of these policies.

Authorities frequently did not utilize higher natural resource revenues to reduce budget deficits, and tended to spend them inefficiently. Counting on high current and future income, expenditures were brought into line with this anticipated high-income level within a relatively short period of time. As a result, the budget deficit widened (Mexico, Nigeria). In some cases, countries borrowed heavily against their anticipated future oil income (Algeria, Venezuela). In addition, authorities often granted large wage increases to public sector employees (Trinidad and Tobago, Nigeria, Venezuela) and created new government structures with new positions. Later, financing increased wage bills contributed to higher inflation, as the authorities found it difficult to reverse nonsustainable expenditure levels once the windfall subsided.

In expectation of continued revenue from the resource boom, authorities undertook ambitious public domestic as well as foreign investment projects with low economic rates of return, politically attractive payoffs, inadequate screening, and undiversified risk (Algeria, Trinidad and Tobago, Nigeria, Iran, Cȏte d’Ivoire). Often such projects served the interests of well-connected individuals. Furthermore, the maintenance costs of these large, nonviable projects were underestimated, and following the resource boom, the government faced the difficult trade-off of sharply reducing other expenditures, postponing their implementation, or stopping project maintenance completely (Nigeria, Mexico, Indonesia). The discontinuation of such projects would leave valuable financial resources wasted and former employees jobless.

The windfall associated with the natural resource boom weakened the authorities’ commitment to undertake necessary restructuring of underdeveloped sectors. Subsidies to these sectors, which were easy to finance during the boom, became hard to maintain after revenues from the booming industry declined. The ailing sectors would have functioned without subsidies, or at least with substantially smaller subsidies, had they undergone the necessary restructuring during the boom times. In general, authorities of countries endowed with rich natural resources tended to be overly confident and underestimated the need for the creation and development of growth-conducive institutions and infrastructure (Gylfason, 2001).

The exploitation of natural resources often promoted rent-seeking behavior, especially under conditions of inappropriately defined property rights and lax law enforcement. Windfall revenue from an export boom also contributed to social problems such as corruption and caused further imbalance in the income distribution. The neglect of the environmental impact of natural resource exploitation led to unrecoverable damages, requiring a high cost of restoration (Nigeria, Ecuador, Indonesia).

Following a natural resource boom, stop-gap policies adopted to counteract the resultant economic imbalances tended to have a further negative impact on the economy. After an adverse terms-of-trade movement, the traditional traded-goods sector was not in a position to earn the necessary foreign exchange, and authorities employed protectionist policies such as restrictive quantitative controls, import quotas, higher tariffs, and bureaucratic barriers to prevent foreign exchange outflows. Such inward-looking policies hurt the manufacturing sector and made repayment of external debt difficult (Ecuador, Nigeria, Mexico).

Many natural-resource-rich countries created savings or stabilization funds with the aim of protecting the domestic economy from a volatile path of natural resource revenues or for saving the windfall resources for future generations. One study of the experience of such funds in five selected countries (Fasano-Filho, 2000) showed that saving natural resource revenues in such funds and investing the funds’ resources abroad might have contributed to limiting domestic spending pressures (spending effect) and reducing real exchange rate appreciation during periods of a rising price for the natural resource (Norway, Chile). The same study concludes that the experience with stabilization funds has at times been less positive, due to frequent changes in the funds’ rules and deviations from their intended purposes (Venezuela, Oman). Success did not lie in the creation of such funds, but rather in fiscal discipline and sound macroeconomic management.

To avoid the consequences of a mismanaged natural resource boom, Azerbaijan will need to make important decisions about consumption, savings, and investment policy and not relax its attention to underlying structural problems. If the country does not prepare itself properly before the boom occurs, this may at the end bring economic disorder.

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