moderneraThis is the first in a series of studies conducted as part of a program to analyze historical precedents and develop recommendations on how to diversify resource-based economies.

The project is being implemented by the Carnegie Moscow Center with financial support from the U.K. Foreign and Commonwealth Office. In addition to creating a large volume of analytical material, its aim is to formulate specific recommendations for countries undergoing or emerging from a resource boom. (These recommendations will of course depend on variables such as the size of the population and economy, the institutional framework, political and economic history, and the proportion of these resources in the GDP.) The main focus of the project is Russia.

As the world reaches the end of an almost fifteen-year period of abnormally high hydrocarbon prices, it makes sense to limit the research to countries that experienced hydrocarbon dependence at the beginning of the twenty-first century and to assess the success of different approaches to economic diversification adopted by those countries. This is particularly relevant for Russia, a country whose economy and political system have changed significantly thanks to the inward flow of petrodollars.

This study contains comparative descriptions of the economic development of ten countries, all of which are leaders in the production and export of hydrocarbons. The research covers a period lasting through the second half of the twentieth century up until the present day. Despite huge differences in the different cases—ranging from civil war and revolution to sustainable prosperity, from welfare states to nations with shocking inequality, from very open to completely isolated economies—we can still draw several interesting conclusions from the comparative study.

In all cases, in countries with very different political systems and economic policies, abnormal revenues from the export of abundant mineral resources have had the effect of distorting the economy.

Achieving economic diversification in countries dependent on oil exports is a major challenge. Most diversification strategies have failed, and there are no examples of countries that have successfully managed to fully diversify away from oil. The success or failure of a diversification strategy depends above all on the implementation of appropriate economic policies. But most governments are conservative: even amid falling oil prices, a government with access to natural resources generally manages to preserve the structure of the economy without experiencing any social upheaval.

Moreover, our study shows that diversification, which is always a long and slow process, usually grinds to a halt during periods of rising oil prices.

Some factors do have a positive impact on states that are attempting this strategy. They include the openness of the economy, a government’s ability to attract foreign capital, and the removal of trade barriers. In none of the cases examined here did these policies lead to a new economic dependence or to a change in the political system.

A powerful country, which acts as a partner to the resource-dependent economy and derives economic benefit from the availability of its cheap labor and access to its territorial resources, can play a key role in the process of diversification, without increasing the economic risks.

Experience shows that when reforming the economy to lessen dependence on resource revenues, it is important to maintain people’s incomes through mechanisms such as the welfare state or a centralized redistribution of wealth. It is dangerous for the stability of the state if it ignores the interests of large social groups when it is undergoing reform.

Another useful tool is found in sovereign funds set up during periods of economic growth resulting from high oil prices. They can be used in transition periods to fill gaps in public sector financing caused by reduced revenues from resource exports and to maintain liquidity in the economy. These funds will work best if they are managed as much as possible as if they were private equity funds.

The competence and management experience of those implementing the policies is another key factor, which means that attracting foreign managers can have a positive impact. That makes tackling corruption a high priority, whether by adopting modern standards of transparency, integrating the country into the global legal environment, adopting international regulation standards, or moving the country toward a British-style legal system.

There is a strong correlation between the success of countries in showing that doing business is a low-risk activity and their success in fighting resource dependency and promoting diversification. Risks for investors increase not only if a system is too weak to protect economic rights, but also if a government is inconsistent and unable to take responsibility for enforcing social and business contracts, in the broadest sense of that term.

If there is an effort to develop non-oil industries then a policy of import substitution—promoting domestic production at the expense of imports from abroad—tends to stunt economic development. Uncompetitive manufacturing companies spring up, which require subsidies from the resource sector. As consumer incomes rise as a result of the distribution of export revenues, the products of these companies still end up being displaced by imports.

On the other hand, a policy of diversification of exports, even if starts from an initially weaker base, allows the use of investment from resource sectors to create a competitive industry and service sector, even if the share of imports increases because of consumption. With this in mind, concerns about the creation of high-tech industries with high added value in the absence of a visible competitive advantage are unwarranted. Experience shows that the creation of high-tech clusters such as these ends up being a success, if all other conditions are met.

The redistribution of revenue from resources can be effected in two ways: either through a policy of obtaining greater revenues from these resources, coupled with a reduction in taxation, or through lower resource revenues and increased taxation. The first method leads to more stratification but greater diversification by increasing the motivation to create alternative businesses and obtain non-resource income. The second method creates a more even distribution of income but reduces the diversification of the economy.

A rise in public spending, including investments in any area, pushes the economy toward businesses with low added value, a process that has a negative impact on the overall growth and diversification of the economy. It is clearly preferable to pursue a policy of creating state reserves, limiting public sector spending, and creating the conditions to attract private and foreign investment.

The most important challenge in diversifying the economy is to keep the costs of non-oil industries to an acceptable level. As labor costs comprise a significant component of the overall costs, efficient cost-cutting measures include:

differentiated tax cuts (in particular on corporate income, staff wages, and personal income) in

 

  • areas not related to natural resources
  • other forms of subsidies, such as on exports
  • attracting cheap labor from abroad for non-resource industries

 

As the first two measures risk reducing the competitiveness of non-resource industries, a policy to actively attract labor migrants appears to be the most beneficial of these options.

This paper is a part of “Comparative Analysis and Policy Proposals Aimed at Diversifying the Russian Economy and Enhancing Prosperity” project, supported by the UK Foreign and Commonwealth Office.

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