How To Fight The Resource Curse

By Brent Radcliffe | October 25, 2011 AAA
How To Fight The Resource Curse

Emerging markets have been a buzz phrase for so long that the absence of news about countries such as Brazil, China and India, is cause for alarm. While developed countries in Europe and the United States have struggled to kick start GDP growth in the wake of the financial crisis, developing countries have been chugging along.

TUTORIAL: Economic Indicators: Gross Domestic Product

Developing countries have some big advantages when it comes to modernizing their economies. They have a lot of excess capacity, can reap quick benefits from adopting advanced technology, can tap into an underutilized workforce, and can make rich world leaders squirm, as they try to ink trade deals. It's the sort of attention that forgotten countries love.

How quickly are developing countries growing? According to the World Bank, the real GDP growth rate for China has not dipped below 7.6% or India's below 3.8% since 1990. Growth rates in the United States, Japan, Germany, France and United Kingdom, five of the top six countries in terms of total GDP, have not broken the 4% barrier in a decade. The MSCI Emerging Markets Index, an index which measures the performance of 21 emerging market equity indexes, had increased 50% between July 2009 and July 2011. For some, this growth has been on the back of strong commodity exports to both advanced and other developing economies.

Demand in countries such as China, Brazil and India led to a boom in commodities exports during the 2000s. The International Monetary Fund's index of primary commodity prices shows that metals prices increased nearly 350%, between September 2001 and August 2011. The only period in which prices fell was during the 2008-09 recession, though that was but a temporary dip, followed by another surge. Markets hungry for growth can't get enough steel, copper and other metals for construction and manufacturing projects. (For related reading, see An Introduction To The International Monetary Fund.)

Commodities
While many developing countries may be rich in commodities, only the development of a domestic industrial base and an internal market, will push the economy forward. Economies relying heavily on commodities could be faced with the "resource curse," an economic phenomenon also known as Dutch disease. A focus on commodity exports can lead to increased capital inflows from international investors. As more money pours into a country it "heats up" and its currency appreciates rapidly. As the currency appreciates, it makes the country's non-commodity exports more expensive, which in turn leads domestic manufacturers to see a decline in orders for their products. In short, commodities crowd out other industries and unemployment, instability and default can follow.

Have capital inflows really been a threat? One way to examine how much of a draw a country is to investors, is to check out foreign direct investment (FDI) inflows. According to the World Bank, FDI for OECD countries in 1992 was $133 billion, 76% of the total world FDI. By 2010, this figure was $695 billion, but its percentage of world FDI fell to 52%. Where did investors look? Emerging markets; investment in Brazil, China, India and Russia jumped from 8% of total FDI to 22%.

Exchange Rates Plummet
What has this done to exchange rates? The Brazilian real, Russian ruble, Indian rupee and Chinese yuan all appreciated, compared to the U.S. dollar, between August 2006 and August 2008, with the real doing so by 40%. The economic downturn in 2008 sent exchange rates plummeting, something exporters adore, but all returned to appreciating between August 2009 and August 2011, with the real once again leading the pack with a 20% appreciation to the dollar.

What can governments do to minimize the possibility of the resource curse rearing its ugly head?

  • Create sovereign wealth funds. Funneling revenue from exports into a SWF, cools off investment before it reaches the economy.
  • Reduce reliance on commodity exports. This can come about by putting emphasis on the development of non-commodity industries and by reducing corruption from rent-seeking government officials and oligarchs.
  • Develop internal markets for goods and services. Industries build off of each other and creating internal demand gives businesses a place to sell their goods, when international demand is low.
  • Invest in education, healthcare and infrastructure. A healthier, well-educated population is more innovative and entrepreneurial. Better roads make it easier to deliver goods.
  • Keeping borrowing in check. Officials need to curb excessive borrowing based on the strength of current commodity prices, as prices may fall in the future.

Even the intervention of central banks may not be enough to combat currency appreciation. Policies designed to push down currency values, such as quantitative easing, can be offset by an influx in investment from investors fleeing rich world economies in dire straits. While a cheaper currency may help a developing country capture a bigger share of the export market, this might not matter if the amount of goods being purchased doesn't recover from a global economic crisis. According to the WTO, exports of manufactured merchandise exports grew by 8% in 2007, but fell 15.5% in 2009. China, the world's top exporter, saw orders fall 16% in 2009; the United States, the top importer, brought in 26% fewer goods. (For related reading, see What Are Central Banks?)

The Bottom Line
Why would a country rich in natural resources want to specialize in manufacturing, especially if there is a high demand for the type of commodity it can export? In short, the future is the problem. It is difficult to predict just how long a reserve of natural resources will last, let alone what the prices for the resource will be in the distant future. Without a functioning non-commodity sector an economy will be lopsided, and because manufacturing is capital-intensive, it won't reappear overnight.

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