How Is the Economic Crisis Changing the Management of Resource Wealth?
1 January 2010
What impact has the economic crisis had on resource rich countries?
The global economic downturn, which began as a sub-prime mortgage crisis in the U.S. in August 2007, has affected all regions of the world, pushing many nations into a deep economic recession. The global outlook deteriorated dramatically in September 2008, following the default of a large investment bank and the government bail-out of the largest insurance company in the U.S.
While resource rich countries have not experienced all the direct effects of the financial crisis, given their low exposure to international capital markets, adverse consequences have affected in the real sectors of many resource abundant economies. These economies are particularly vulnerable because of their dependence on the extractive sector for generating fiscal revenues and export earnings.
Commodity prices dipped at the beginning of the downturn. Oil prices decreased from $137 per barrel in July 2008 to $35 barrel by the end of that year; over the same period copper prices fell from $4/lb to $3.1/lb. Yet commodity price shock has been relatively mild and price returned to 2007 levels by mid-2009. As a result of the decline in commodity prices, windfall revenues also plummeted and both export volumes and earnings shrank, significantly dampening growth prospects. Countries with excessive dependence on the mineral sector faced an especially precarious situation because they had failed to diversify beyond the commodities market.
Global output fell by one percent in 2009, and the downturn was much more severe in high-income economies. Although resource dependent countries grew at an annual rate of about 2 percent in 2009, the decline in growth rates has been more pronounced in these countries than in the G7 or resource-poor emerging market or developing economies.
How do governments manage resources in “good times”?
When commodity prices are high and economies are growing rapidly, resource rich governments usually find it difficult to resist political pressures to increase public expenditures. Yet, when prices drop, bust cycles usually compel governments to trim their budgets. In the 1980s, for example, a number of oil-rich countries had to dramatically cut public expenditures, causing a significant reduction in the provision of public goods.
Informed by the lessons from previous boom episodes, most resource rich countries showed greater fiscal restraint during the latest boom cycle and managed to accumulate significant windfall reserves in order to smooth government spending over time. The World Bank estimates that the average general government fiscal surplus in oil exporting countries increased from 0.6 percent in 2000 to 7.7 percent in 2007. Public expenditures in resource dependent countries increased at a slower pace than during the previous boom and government expenditures as a share of GDP declined by five percent. In addition, petroleum-exporting countries substantially increased their foreign exchange reserves and many created new sovereign wealth funds or extended preexisting funds. The combined assets of these funds in energy exporting countries had reached over $2,167 billion by mid-2008.
What can the crisis teach us about natural resource funds?
The commodity price volatility seen in the most recent boom-bust cycle has reinforced the case for saving a portion of windfall revenues. However, the current turmoil also shows that accumulating reserves without capping international borrowing by the private sector–financial institutions and the corporate sector–can lead to over-borrowing and overheating in the economy. For instance, Kazakhstan accumulated about $27 billion (20 percent of GDP) in its Oil Fund during the boom cycle, while Russia amassed more than $230 billion (15 percent of GDP) in its twin funds. But the banking sector in Kazakhstan and quasi-state corporations in Russia had each borrowed heavily from abroad, increasing vulnerability of these economies to external shocks.
Many resource dependent countries with large stabilization funds have tapped into their foreign exchange reserves to help them weather the crisis more effectively than some other countries. They have maintained pre-crisis level spending, bailed out the ailing financial sector, intervened in the foreign exchange market to maintain pegs to the U.S. dollar, and supported domestic credit markets. Chile, for example, mobilized its savings and avoided a steep economic decline. Kazakhstan and Russia used oil money to avoid dramatic fiscal adjustments and support their financial sectors. The current economic downturn will undoubtedly serve as a lesson for future economic policies in dealing with commodity price volatility and windfall revenue uncertainty.
The most important lesson emerging from the downturn is that while the creation of a national resource fund may help in maintaining macroeconomic stability and achieving a fair distribution of natural resource wealth across generations, these funds are no substitute for genuine economic diversification.
What can the crisis teach us about economic policy and opportunities for reform?
Although many resource dependent countries were able to cushion some of the impact of the global recession, through a decade of prudent macroeconomic policies, lagging structural reforms and government failures to foster diversification also increased their vulnerability to external shocks. This problem can be seen clearly in Azerbaijan, Mongolia and Russia, where governments to take advantage of a decade-long boom to diversify.
Botswana has also been among the hardest hit commodity dependent countries. Diamond production was suspended during the first half of the year by the joint venture controlled by De Beers and the Botswanan government, and exports have only recently started to rebound. Botswana's economy is poorly diversified and extremely dependent on mineral production, which represents 75 percent of export earnings. As a result, drops in prices and production have sparked a GDP contraction projected at 12 percent for 2009, and the budget deficit is expected to deepen and reach 11.2 percent of GDP.
The crisis also threatens to hamper future diversification and reinforce resource dependency. While most resource rich countries maintained or exceeded their pre-crisis levels of overall public spending in 2009, total investment in fixed capital formation appears to be declining. Public and private spending on fixed investment in these countries is estimated to have contracted by 5 percent in 2009, while emerging economies as a group are expected to scale up their fixed investment outlays by about 4 percent. If this trend continues, a dramatic reduction in fixed investment will impede diversification efforts and deteriorate growth potential, exacerbating the very problem that initially jeopardized resource rich countries
What are some good practices for coping with the economic crisis?
Countries that were able to design and implement timely, diversified and flexible countercyclical fiscal policies managed to ease the adverse impact of the crisis on the economy and the vulnerable groups. Some common measures governments have taken to mitigate the effects of the crisis include fiscal stimulus packages to restore confidence in the financial sector; cuts in interest rates; the revision of budget expenditures; assistance for key sectors of the economy and diversification through investment in nontraditional sectors; strengthening banking sector regulation; and imposing foreign exchange controls to defend the exchange rate.
Governments that managed to keep pre-crisis level credit flows and investment activities were also better able to mitigate the negative impacts of the crisis. Most resource rich countries in the Middle East and North Africa, for example, have weathered the financial crisis better than their counterparts in other regions. In particular, oil-exporting Middle Eastern countries implemented huge investment projects in the bonanza years to promote diversification and develop human capital. The financial sector in this region was healthier than in the other regions, and governments' crisis response measures focused on liquidity support, capital injections and an accommodating monetary policy, further strengthening the banking industry. Finally, despite the crisis and falling revenues, most of the countries holding huge reserves increased their fiscal spending and maintained investment expenditures at the pre-crisis level.
Chile is another example of sound management and use of reserves in the face of crisis. The Chilean government had more than $20 billion in its Economic and Social Stabilization Fund when the global crisis hit. In November 2008, officials approved a $1.15 billion package to spur lending to middle income families and small and medium-sized businesses. In January 2009, the government also unveiled an aggressive $4 billion stimulus package that included new investment by Codelco, the national copper company, public works projects and public support for the most vulnerable Chileans. After a recession of 1.2 percent in 2009, the country is projected to grow again at 3.5 percent in 2010.