Escaping the Resource Curse

By Mauricio Villafuerte

(Version in عربي)

It reads like a script for a Hollywood movie—a poor protagonist happens upon an opportunity that has the potential of bestowing riches, but an evil curse threatens to spoil it all.

Unfortunately, it’s not a movie script. The scenario plays out repeatedly in many parts of the real world all the time. For many developing countries, managing natural resources and the increased revenues they bring is a tough haul.

Cue the extensive literature on the “resource curse” and the lack of consensus on how to run fiscal policy and manage budgets in resource-rich countries.

In some respects, this is like the “all-too-similar” sequel, because the tribulations associated with how to best manage natural resources, such as oil, minerals, and gas, seem to endure so that resource-rich developing countries are never quite free of them.

The “resource curse” and fiscal policy

High commodity prices and the discovery of new reserves offer the potential for much needed revenue in many developing countriesrevenues that should help promote economic and social development, build human capital, and reduce infrastructure gaps in resource-rich countries. In a new study, my co-authors and I look at how to manage fiscal policy to achieve those goals while avoiding previous pitfalls.

The design of fiscal policy frameworks for resource-rich developing countries is beset by trade-offs and tensions. In fact, the volatility, uncertainty, and exhaustibility of revenues earned from resources have to be taken into account when formulating a scaling up of public spending.

  • How to ensure short-term macroeconomic and fiscal stability?
  • How to achieve long-term fiscal sustainability and adequate savings for future generations while allocating sufficient resources to meet development needs?
  • How to address absorption capacity constraints that could limit the quality and effectiveness of scaled-up spending?

These are important questions that many politicians, policymakers, and economists face in such countries.

Recent academic and empirical work has enhanced the debate on this issue. On the one hand, such work has brought to the fore the need to avoid rigid policy formulations that would force countries with substantial development needs to keep the consumption of their resource wealth at a constant level over time (that is, borrowing at the beginning, saving when income is high, and lowering the rate of saving as income tapers off).

While persuasive, such work hasn’t offered practical approaches to managing fiscal policy in those countries and overemphasizes the role of resource funds, for example.

So, how could fiscal frameworks for resource-rich countries be made more flexible in practice? In our study, we analyze this question from a practitioner’s perspective, proposing specific options to effectively anchor fiscal policy while allowing for a sustainable scaling up of spending in the context of increased resource revenue.

In laying out the options, our study emphasizes that there is not a “one size fits all” approach since each country has its own set of economic and institutional circumstances to balance, such as resource revenue dependency, how long the reserves will last, and the country’s development needs. Furthermore, the large volatility of revenues earned from natural resources and the difficulty to predict those swings would call for prudence and gradualism in scaling up spending and for flexible fiscal rules to adapt to new information and changing circumstances.

Seven principles

Accordingly, we propose the following principles to guide the formulation of fiscal policy frameworks in resource-rich developing countries:

  • The framework should reflect country-specific characteristics like revenue dependency and volatility as well as how long the resource revenue stream is expected to last—all of which may change over time.
  • It should ensure the sustainability of fiscal policy. Depending on how many years the natural resource is expected to last before it is depleted, benchmarks of sustainability can be derived from simple constant consumption approaches—particularly for countries with short-lasting reserves—or from a broader focus on stabilizing government net wealth (not now, but over the long run).
  • Policymakers can choose alternative fiscal anchors, either primarily addressing fiscal sustainability concerns (for example, permanently constant non-oil balance deficit rules) or focusing more on short-term demand management (such as a price-based or structural balance rule). Country characteristics should guide the choice of the appropriate fiscal anchor (see table below).
  • Frameworks should be sufficiently flexible to enable the scaling up of growth-enhancing expenditure (for example, public investment to tackle existing infrastructure gaps), especially in low-income countries.
  • In countries with large absorption constraints, the pace of scaling up may have to be gradual, while public financial management systems are reinforced and domestic supply constraints softened.
  •  The volatility and uncertainty of resource revenue is critical for the design of fiscal frameworks, and having sufficient precautionary fiscal buffers is critical. A strong revenue forecasting framework needs to be developed and spending plans framed in a medium-term perspective.
  •  The credibility and transparency of the framework can be supported by a well-designed natural resource fund. But the fund cannot be a substitute for an appropriate policy framework nor a panacea that obviates the need to strengthen overall fiscal management capacity. Funds need to be fully integrated with the budget and the fiscal framework.

The complete framework would comprise three elements:

    1. Fiscal policy indicators–the best analytical measures of the actual stance of fiscal policy.
    2. Fiscal sustainability benchmarks–provide a way to assess fiscal policy with a longer-term perspective.
    3. Fiscal policy anchors–the rules or guidelines that would better fit resource-rich countries and their specific characteristics.

The table below illustrates the more appropriate rules possible along two specific dimensions: the horizon of their resource reserves and the relative scarcity of capital.

4 Responses

  1. I spent many years writing about oil-rich countries in West Africa. Any time I see words such as ‘anchor’ I despair. An anchor is effectively a promise by politicians to be disciplined. Yet the anchor is supposed to address the key problem which is . . . indiscipline. It’s kind of a circular argument. It’s a bit like the argument which says that the best way to tackle corruption is for people to be less corrupt.

    At the margin, and in countries which already have strong institutions, I think recommendations like yours can certainly help. But the central dynamic of African resource-rich countries that I have known is one where the collective effort of national self discipline is impossible because of patronage-based politics where everyone is in competition to snaffle what they can for them and their supporters before someone else does, and the result of this at a national level is unrestrained pro-cyclical borrowing and spending.

    People can be individually disciplined, but collectively the nation can’t.

  2. Sustainable fiscal policies are necessitated not only by the already-high level of public debt and rising interest payments in many countries. A particular cause for concern is the dramatic increase in financial burdens that budgets will face in the future owing to the aging of the population.

    In the context of fiscal policy, sustainability means that it remains permanently possible to take effective action on budget matters and that fiscal policy contributes to preserving the foundation for a growing economy. The question is whether the current fiscal policies satisfy these conditions or whether financing gaps will arise in the future that will have to be closed through tax hikes or spending cuts.

    There are a number of factors that point to a need to evaluate the sustainability of fiscal policies. Initial insights are provided by the annual funding deficit. However, that is ill-suited to serve as the sole criterion in evaluating the sustainability of fiscal policies, mostly because it is too short-term in nature and is also susceptible to manipulation. Among the principal indicators of sustainability that have been developed are the OECD concept of “fiscal sustainability” and the generational accounting method. Both approaches are based on a longer-term projection of budget trends, but there are significant differences in how they are set up.

    The OECD concept involves examining the development of government revenues and spending over a defined period, such as thirty to forty years. The underlying assumption is that current fiscal policies will be perpetuated. Under this approach, fiscal policies are sustainable if their long-term application brings about a situation in which the debt/GDP ratio at the end of the observation period – despite impending additional fiscal burdens – does not exceed its current level. Accordingly, fiscal policies that do not satisfy these conditions amid increased spending or decreased revenues over the long term are not sustainable. The “sustainability gap” indicates to what extent the budget needs to be consolidated in order to restore fiscal policy sustainability.

    Calculations show that sustainability gaps exist in most countries, in some cases considerable ones. This suggests a significant medium-term need for consolidation in public finance.

    Care should be exercised in interpreting the results, however, because such sustainability indicators are encumbered by a number of problems. For example, substantial difficulties arise when forecasting how public revenues and spending will develop over a lengthy period. Another problem relates to how the perpetuation of current fiscal policies is to be defined in the projections. Still, the Advisory Board believes that the OECD concept could make an important contribution to assessing the sustainability of fiscal policies.

    The generational accounting concept is similarly concerned with future developments in income and spending in the national budget. In this case, the analysis period is actually many times longer than the period under consideration in the OECD concept. One characteristic of this approach is that tax payments (including social security contributions) and public spending are attributed to individual generations, and the net tax payments of each generation are determined as the difference between their tax payments and benefits received. Sustainability is present if the net tax payments of all generations are adequate to fund sovereign debt commitments. Applied empirically, this approach too points to substantial sustainability gaps, which are described with two different indicators. In the “base-year” version, the sustainability gap indicates the overall need for consolidation, very similarly to the OECD concept. In the “generational” version, meanwhile, the assumption is that only future generations are called on to cover the sustainability gap.

    The generational version is also open to criticism for further dramatizing the already-serious need for consolidation by assuming that fiscal policies are a constant over a very long period, despite higher spending and larger funding gaps, and by saddling future generations exclusively with the job of closing the sustainability gap. The unusually long analysis period itself also seems quite problematic. Because of these weaknesses, the Advisory Council considers the OECD approach overall the better-suited instrument for analyzing sustainability.

  3. […] – Escaping the resource curse. […]

  4. […] Escaping the Resource Curse « iMFdirect – The IMF Blog […]

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