1. Thorvaldur Gylfason IMF INSTITUTE Course on Natural Resources, Finance, and Development Stellenbosch, South Africa November 15-26, 2010

2. 1.Economic geography, old and new 2.Sources of growth 3.Extraction rules 4.Natural resources and economic growth: Selected policy issues 5.Cases and success stories Botswana, Chile, Mauritius, Norway Mixed blessing? Keys to success? 6.Empirical evidence

3.  Assigned key role to natural resource wealth and raw materials  Tended to equate those resources with economic strength  Yet, many resource-abundant countries are poor, while several resource-poor countries are rich  Prime Minister Putin of Russia:  “Our country is rich, but our people are poor.” 1

4. National wealth Intangible capital Physical capital Natural capital In the world as a whole, natural capital constitutes a small part of national wealth, or about 6% Even so, natural capital remains important in a number of countries Advanced countries (US, Canada, Australia, and others) have outgrown their dependence on natural capital, including agriculture

5. bluered From blue to red: Increased resource intensity Tangible capital is produced capital plus natural capital, and does not include human capital and social capital

6. bluered From blue to red: Increased resource intensity Total capital is produced capital plus natural capital plus tangible capital, including human capital and social capital

7. human capital social capital  Recognizes several different sources of wealth, emphasizing human capital and, increasingly, social capital governanceinstitutions  Social capital refers, among other things, to governance and institutions  Many resource-rich countries have fared badly, while several resource- poor countries have done well  There are many kinds of capital and many different sources of growth

8. Lee Kwan Yew  Listen to Lee Kwan Yew, founding father of Singapore (1959-1991): natural resources people education  “I thought then that wealth depended mainly on the possession of territory and natural resources, whether fertile land..., or valuable minerals, or oil and gas. It was only after I had been in office for some years that I recognized... that the decisive factors were the people, their natural abilities, education and training.”

9. 1.Saving and investment Real capital 2.Education, health care Human capital 3.Exports and imports Foreign capital 4.Democracy and freedom Social capital 5.Stability Financial capital 6.Diversification away from Natural capital Effects on growth are undisputed Effects on growth are somewhat controversial 2 Extensive vs. intensive growth

10. 1.Saving and investment Real capital 2.Education, health care Human capital 3.Exports and imports Foreign capital 4.Democracy and freedom Social capital 5.Stability Financial capital 6.Diversification away from Natural capital All six are generally considered desirable in and of themselves How to attain these goals is another matter All six are generally considered desirable in and of themselves How to attain these goals is another matter Efficiency, institutions, and governance

11.  How much government involvement is needed to diversify?  Pros and cons of industrial policy (Rodrik, 2004) Picking winners seldom works, but cutting losses can be fruitful Presupposes competent civil service Prone to political capture and corruption, but so is, e.g., privatization as in Russia Never works? But recall successes in South Korea and Latin America, e.g., Chile Support for R&D vs. entrepreneurship à la Pigou Do international rules leave limited scope for industrial policy?

12.  Two suggestions  Encourage new industries in line with country’s comparative advantages and available expertise in public administration  Follow the market rather than try to take the lead  Need solutions based on general principles and tailored to specific circumstances  Not one-size-fits-all

13.  Opportunities for finance – and pitfalls  Banks pick customers, some win, some lose  Example from Iceland  Fishing rights are allocated free of charge to boat owners even if, by law, Iceland’s fish is a common property resource  Fishing quotas were quasi-legally used as collateral for crushing private debts intended to support their branching out as well as speculation  Banks were privatized in like manner, and crashed promptly

14. Growth Real capital Investment Human capital Education Fertility Social capital Corruption Democracy Financial capital Inflation Natural capital Resource depletion drag Leave out foreign capital for simplicity Governance affects linkages

15. Cobb-Douglas production function K/Y is constant Collect Y on left-hand side Solve for Y Divide through by L

16. If N, e.g. oil wealth, declines by u% per year, then g N = -u Oil extraction u slows down growth as does population growth g L

17. Natural capital EducationCorruptionDemocracyInvestmentFinance

18. Growth Investment Exports Education Stability Diversification Double diversification Double diversification is good for growth, and for other determinants of growth

19. Listen to King Faisal of Saudi Arabia (1964-1975): “In one generation we went from riding camels to riding Cadillacs. The way we are wasting money, I fear the next generation will be riding camels again.”

20. Question: When is the best time to fell a tree? Answer: When the growth rate of the tree equals the rate of interest, or thereabouts Simple logic based on dynamic optimization 3

21.  Volume of lumber per tree is f(t) where t is time, with f’(t) > 0 because tree grows over time at g = f’(t)/f(t)  Value of tree is pf(t) where p is price per unit  This is what owner can sell the tree for at time t  If he cuts down the tree and invest pf(t) for  t, interest earned will be rpf(t)  t  If owner waits for  t, value of tree increases by pf(t) + pf(t+  t) = pf’(t)  t  Optimal time to fell the tree is when MC = MR:  pf’(t)  t = rpf(t)  t, i.e., f’(t)/f(t) = r, i.e., g = r  Provided that price of land is constant g = r

23.  If price of land p L is variable, total revenue becomes h(t) = pf(t) + p L  By same logic as before, optimal time to cut tree is when h’(t)/h(t) = pf’(t)/[pf(t)+p L ] = r  Price of land equals its present value:  p L = e -rt [pf(t)+p L ]  Therefore, p L = pf(t)[e -rt /(1-e -rt )]  Plug this into h’(t)/h(t) = pf’(t)/[pf(t)+p L ] = r  This gives h’(t)/h(t) = (1-e -rt )f’(t)/f(t) = r  Hence, MC = MR gives f’(t)/f(t) = r/(1-e -rt ) > r g > r

25.  Hartwick rule defines the amount of investment in produced capital (buildings, roads, knowledge stocks, etc.) needed to exactly offset declining stocks of non- renewable resources …  … so that standard of living does not fall as society moves into indefinite future  Hartwick rule –"invest resource rents!" – requires nation to invest all rent earned from exhaustible resources currently extracted  Rent is defined along paths that maximize returns to owners of resource stock  If part of rent is consumed, total wealth declines

26.  Hotelling rule specifies the optimal rate of extraction of an exhaustible – i.e., nonrenewable – resource …  … so that the stock of the resource declines to zero at a pace that maximizes the revenue or rent from the resource to its owner  Too slow extraction will not produce maximum rent, nor will too rapid extraction  The trick is to find the optimal rate, i.e., the rate of extraction that maximizes the present value of the resource rent

27. E(t) = extraction cE(t) = cost of extraction S(t) = stock or resources p(t) = price of resource, or dynamic rent, or dynamic royalty r = interest rate E(t) = extraction cE(t) = cost of extraction S(t) = stock or resources p(t) = price of resource, or dynamic rent, or dynamic royalty r = interest rate Extract resource at a rate that makes its value grow at r

28. Four main areas 1.Fiscal policy 2.Monetary, financial, and exchange- rate policy and the Dutch disease 3.Institutions and governance 4.Diversification  Economic  Economic, away from excessive dependence on a few resources  Political  Political, away from narrowly based power elites 4

29.  Natural resource wealth is an efficient tax base because resource taxation causes minimal distortions to economic behavior  Case in point: Iceland’s missed opportunity  Could have auctioned off catch quotas and used proceeds to abolish personal income taxes  Chose instead to allocate fishing quotas to boat owners free of charge  Then chose to privatize its banks the same way, and they all collapsed a few years later in 2008  Important to reduce other less efficient taxes to keep overall tax burden reasonable  Also, spend tax revenues efficiently Taxes vs. fees Pigovian principle

30.  Price stabilization funds  Build up reserves when commodity prices are high  Use up reserves when prices are low Aim is to shield producers from price fluctuations Subject to similar reservations as stabilization policies  Example from Chile  Government can run a deficit larger than the target of zero, or 1% surplus, to the extent that Output falls short of potential, or Price of copper is below its medium-term (10-year) equilibrium Two panels of independent experts determine the output gap and the medium-term equilibrium price of copper

31. Foreign exchange Real exchange rate Imports Exports without oil Exports with oil A CB Oil discovery leads to appreciation, and reduces nonoil exports Composition of exports matters

32.  Term refers to fears of de-industrialization that gripped the Netherlands following appreciation of Dutch guilder after discovery of natural gas deposits in North Sea around 1960  Is it a disease? No  Some say No, viewing it simply as matter of one sector’s benefiting at the expense of others, without seeing any macroeconomic or social damage done Yes  Others say Yes, viewing the Dutch disease as an ailment, pointing to the potentially harmful consequences of the resulting reallocation of resources – from high-tech, high-skill intensive service industries to low-tech, low-skill intensive primary production, for example – for economic growth and diversification

33.  Overvaluation of currency hurts other exports and import-competing industries  Norway’s total exports have been stagnant in proportion to GDP since before oil discoveries  Oil exports have crowded out nonoil exports Nokia is Finnish, LM Ericsson is Swedish, B&O is Danish  Norway’s almost unique unwillingness to join EU  Keeping inflation low to avoid overvaluation monetary governance  Price stability requires good monetary governance through independent yet accountable central banks  Healthy financial sector development also requires good monetary governance, including transparency China’s undervalued renmimbi

34.  Rent seeking …  Especially in conjunction with ill-defined property rights, imperfect or missing markets, and lax legal structures  … tends to divert resources away from more socially fruitful economic activity  International initiatives to raise transparency  Extractive Industries Transparency Initiative  Extractive Industries Transparency Initiative (EITI) aims to set global standard for transparency in oil, gas and mining  Revenue Watch Institute  Revenue Watch Institute (RWI) promotes responsible management of oil, gas, and mineral resources  Natural Resource Charter  Natural Resource Charter sets out principles for how to manage natural resources for development False sense of security Neglect of education False sense of security Neglect of education Other people’s money

35.  Volatility of commodity prices leads to volatility in exchange rates, export earnings, output, and employment  Volatility can be detrimental to investment and growth  Hence, natural-resource rich countries may be prone to sluggish investment and slow growth due to export price volatility  Likewise, high and volatile exchange rates tend to slow down investment and growth

36. Source: http://notendur.hi.is/gylfason/pic22.htm

37.  Fiscal policies need to foster efficient revenue collection as well as efficient, growth-friendly public spending  To be efficient and fair, the utilization of natural resources requires that the owners – the people – be appropriately compensated  Property rights to natural resources belong to the people by international law International Covenant on Civil and Political Rights Article 1 of the International Covenant on Civil and Political Rights states that “All people may, for their own ends, freely dispose of their natural wealth and resources” (Wenar, 2008)  Monetary policies need to avoid overvaluation and excessive volatility of the currency

38.  Consider Norway  From day one, Norway’s oil and gas reserves were defined by law as common property resources, clearly establishing the legal rights of the Norwegian people to the resource rents  On this legal basis, the government has absorbed about 80% of the resource rent over the years  Government laid down economic as well as ethical principles (‘commandments’) to guide the use and exploitation of the oil and gas for the benefit of current and future generations of Norwegians

39.  Norway was a well-functioning, full-fledged democracy long before its oil discoveries  Democrats are less likely than dictators to try to grab resources to consolidate their political power  Elsewhere, point resources such as oil and minerals have proved particularly “lootable”  Petroleum industry has conferred sizable spillover benefits on others at home and abroad through transfer of technology as well as research and development Nigeria’s economy minister: “Oil has made us lazy” Nigeria’s economy minister: “Oil has made us lazy” Norwegians work less than Danes and Swedes, true, but no less than Germans

40. without  Success stories without natural resources  Hong Kong  Japan  Singapore  Switzerland with  Success stories with natural resources  Botswana  Chile  Mauritius  Norway, again  How did they succeed? 5

41.  How Botswana succeeded  Started out at independence in 1966 with 12 km of paved roads, 22 college graduates, and 100 secondary-school graduates  Diamonds, discovered in 1967, provide tax revenue equivalent to 33% of GDP  Sub-Saharan Africa’s highest per capita GNI  Good policies, good institutions, democracy  How Mauritius succeeded  Emphasized trade and education in lieu of sugar  Cosmopolitan population  Again, good policies, good institutions, democracy  Look at some economic and social indicators Frankel (2010) Acemoglu et al.(2003) But not perfect

42. Per Capita GNI (USD at PPP) Increase in life expectancy in years 1980-2008 -6 1 1 6 6

43. Per Capita GNI (USD at PPP)Democracy 7 7 -2 Increase in life expectancy in years 1980-2008 Average democracy index 1980-2008 -6 1 1 6 6 Generally, democracy and growth go together

44. Per Capita GNI (USD at PPP) 10 13 -6

45. Per Capita GNI (USD at PPP)Democracy 4 4 6 6 10 13 -6

46. Per Capita GNI (USD at PPP) 7 7 5 5 6 6

47. Democracy 10 4 4 7 7 5 5 6 6

48. Per Capita GNI (USD at PPP) 5 5 13 12

49. Per Capita GNI (USD at PPP)Democracy 10 -4 -10 5 5 13 12

50.  The problem is not the existence of natural wealth as such...  … but rather the failure to avert the dangers that accompany the gifts of nature  Norway is, so far, a success story 80% of oil rent  Government invests 80% of oil rent entirely in foreign securities  60% in equities  40% in fixed-income securities

51.  Norway always had its natural resources educated labor  It was only with the advent of educated labor that it became possible for the Norwegians to harness those resources on a significant scale  Human capital  Human capital accumulation was the primary force behind the economic transformation of Norway  Natural capital was secondary

52.  The purpose of the oil fund  SharePension fund  Share the wealth fairly: Pension fund  Shield  Shield domestic economy from overheating and possible waste USD 450 billion  Fund has grown huge: USD 450 billion  That makes almost USD 100K per person resisted temptation  Norwegians have resisted temptation to use too much of the money to meet current needs

53. democracy market economy  Long tradition of democracy and market economy in Norway since before the advent of oil  Large-scale rent seeking was averted as oil was, by law, defined as a common- property resource from the beginning  Adequate investment performance  Excellent education record  Female college enrolment doubled from 46% of each cohort in 1991 to 94% in 2006

54. Dutch disease  Some (weak) signs of Dutch disease  Stagnant exports, sluggish FDI  Limited interest in joining EU and EMU  Some signs also of unwillingness to undertake difficult reforms  Health care provision Central Bank  Management of oil fund delegated by Ministry of Finance to Central Bank from 1997 onward  Central Bank became independent 1999

55.  Natural resources bring risks false sense of security  A false sense of security leads people to underrate or overlook the need for good policies and institutions, good education, and good investment may find that hard choices perhaps can be avoided  Awash in easy cash, they may find that hard choices perhaps can be avoided  Awareness of these risks is perhaps the best insurance policy against them

56. 16 countries 4 industrial countries 12 developing countries 16 countries 4 industrial countries 12 developing countries 6

57. 27 countries 5 industrial countries 22 developing countries 0.1% whose average per capita growth rate 1960-2000 was 0.1% per year compared with 1.4% for the sample of 164 countries as a whole 27 countries 5 industrial countries 22 developing countries 0.1% whose average per capita growth rate 1960-2000 was 0.1% per year compared with 1.4% for the sample of 164 countries as a whole

58. High-income countries Low-income countries Real capital 1716 Natural capital Subsoil assets 2 (1) 29 (6) Intangible capital Human capital Social capital 8155  Total wealth  Total wealth: estimated by perpetual inventory method as present discounted value of future consumption  Real capital  Real capital: estimated from investment figures  Natural capital  Natural capital: cropland, pastureland, subsoil assets, timber resources, nontimber forest resources, and protected areas  Intangible capital  Intangible capital: estimated as residual Source: World Bank (2006)

59. School life expectancy 2005 (years) Fertility 1960-2000 (births per woman) Public health expenditure 2004 (% of GDP) Democracy 1960-2000 (index) Corruption 2005 (index) Investment 1960-2000 (% of GDP) Per capita growth 1960-2000 (% per year) Mineral- rich countries 11.74.52.4-3.23.324.30.1 Lower middle- income countries 11.43.62.6-1.23.024.33.6 Upper middle- income countries 13.52.93.82.24.125.91.7

60. False contrast: No inconsistency between favorable effects of commodity price booms on output in the short run and adverse effects on long-run growth Size of balls reflects size of countries -0.67 Natural capital share and growth are inversely related

61. -0.82 Natural capital crowds out human capital

62. 0.69 Education is good for growth

63. -0.74 Natural capital crowds out social capital More corruption

64. 0.75 Corruption hurts growth More corruption

65. -0.67 Natural capital crowds out social capital

66. 0.51 Democracy is good for growth

67. 0.62 Human capital and social capital go together

68. 0.60 Different aspects of social capital go together More corruption

69. -0.67 Natural capital share and growth are inversely related

70. -0.10 Subsoil asset share and growth are inversely related, but rank correlation is weak, so need multiple regression

71. Model 1 Initial income -0.74 (5.2) Natural capital share Natural capital per person Democracy Investment rate (log) School life expectancy (log) Fertility Countries 164 Adjusted R 2 0.14 Note: t-values within parentheses.

72. Model 1Model 2 Initial income -0.74 (5.2) -0.49 (3.1) Natural capital share -0.04 (5.3) Natural capital per person Democracy Investment rate (log) School life expectancy (log) Fertility Countries 164125 Adjusted R 2 0.140.18

73. Model 1Model 2Model 3 Initial income -0.74 (5.2) -0.49 (3.1) -0.96 (5.3) Natural capital share -0.04 (5.3) -0.06 (7.1) Natural capital per person 0.10 (4.5) Democracy Investment rate (log) School life expectancy (log) Fertility Countries 164125124 Adjusted R 2 0.140.180.29

74. Model 1Model 2Model 3Model 4 Initial income -0.74 (5.2) -0.49 (3.1) -0.96 (5.3) -1.07 (5.2) Natural capital share -0.04 (5.3) -0.06 (7.1) -0.05 (4.7) Natural capital per person 0.10 (4.5) 0.08 (3.7) Democracy 0.07 (2.2) Investment rate (log) School life expectancy (log) Fertility Countries 164125124113 Adjusted R 2 0.140.180.290.27

75. Model 1Model 2Model 3Model 4Model 5 Initial income -0.74 (5.2) -0.49 (3.1) -0.96 (5.3) -1.07 (5.2) -1.24 (7.0) Natural capital share -0.04 (5.3) -0.06 (7.1) -0.05 (4.7) -0.04 (5.3) Natural capital per person 0.10 (4.5) 0.08 (3.7) 0.06 (3.3) Democracy 0.07 (2.2) 0.07 (2.7) Investment rate (log) 2.92 (6.8) School life expectancy (log) Fertility Countries 164125124113 Adjusted R 2 0.140.180.290.270.48

76. Model 1Model 2Model 3Model 4Model 5Model 6 Initial income -0.74 (5.2) -0.49 (3.1) -0.96 (5.3) -1.07 (5.2) -1.24 (7.0) -1.60 (7.8) Natural capital share -0.04 (5.3) -0.06 (7.1) -0.05 (4.7) -0.04 (5.3) -0.03 (4.0) Natural capital per person 0.10 (4.5) 0.08 (3.7) 0.06 (3.3) 0.05 (2.5) Democracy 0.07 (2.2) 0.07 (2.7) 0.07 (2.7) Investment rate (log) 2.92 (6.8) 1.72 (3.2) School life expectancy (log) 0.94 (4.0) Fertility Countries 164125124113 90 Adjusted R 2 0.140.180.290.270.480.55

77. Model 1Model 2Model 3Model 4Model 5Model 6Model 7 Initial income -0.74 (5.2) -0.49 (3.1) -0.96 (5.3) -1.07 (5.2) -1.24 (7.0) -1.60 (7.8) -1.70 (8.5) Natural capital share -0.04 (5.3) -0.06 (7.1) -0.05 (4.7) -0.04 (5.3) -0.03 (4.0) -0.03 (3.1) Natural capital per person 0.10 (4.5) 0.08 (3.7) 0.06 (3.3) 0.05 (2.5) 0.04 (2.3) Democracy 0.07 (2.2) 0.07 (2.7) 0.07 (2.7) 0.05 (2.0) Investment rate (log) 2.92 (6.8) 1.72 (3.2) 1.34 (2.5) School life expectancy (log) 0.94 (4.0) 0.56 (2.1) Fertility -0.40 (2.8) Countries 164125124113 90 Adjusted R 2 0.140.180.290.270.480.550.58 OLS

78. Model 1Model 2Model 3Model 4Model 5Model 6Model 7 Initial income -0.74 (5.2) -0.49 (3.1) -0.96 (5.3) -1.07 (5.2) -1.24 (7.0) -1.60 (7.8) -1.70 (8.9) Natural capital share -0.04 (5.3) -0.06 (7.1) -0.05 (4.7) -0.04 (5.3) -0.03 (4.0) -0.03 (3.3) Natural capital per person 0.10 (4.5) 0.08 (3.7) 0.06 (3.3) 0.05 (2.5) 0.04 (2.4) Democracy 0.07 (2.2) 0.07 (2.7) 0.07 (2.7) 0.05 (2.1) Investment rate (log) 2.92 (6.8) 1.72 (3.2) 1.34 (2.6) School life expectancy (log) 0.94 (4.0) 0.56 (2.2) Fertility -0.40 (3.0) Countries 164125124113 90 Adjusted R 2 0.140.180.290.270.480.550.58 SUR

79. Per capita growth (%)2.421.00 Natural capital share (19.0) 0.470.19 Democracy (6.4) 0.350.14 Investment (log, 0.29) 0.390.16 School life expectancy (log, 0.35) 0.480.20 Fertility (1.8) 0.730.30 Note: Standard deviations within parentheses.

80. These slides will be posted on my website: www.hi.is/~gylfason n David Landes (1998) tells the story of Spain following the colonization of South and Central America which made Spain rich in gold and other natural resources: “Easy money is bad for you. It represents short-run gain that will be paid for in immediate distortions and later regrets.”