Mongolia's Natural Resources: A Blessing or a Curse?

February 28, 2006

February 28, 2006 - Intuitively, it seems that any country that is blessed with natural resources should do well. Unfortunately, this is not true. It is the opposite. Many studies have shown that most countries that have abundant natural resources have done less well than those who do not possess such resources. The growth rates of countries with natural resource abundance over the long term, say 30 year period has in most cases been lower than those countries which do not have such natural resources. Why is it so? And is this process inevitable? Can the curse not be overcome? I will try and answer this by first looking at what we observe from around the world and from the various studies. Then I will explain how Mongolia might avoid the pitfalls that digging up its treasures might bring to its society and people.

Natural resource curse: the theory of practice
It is often said that when most people read about a theory, they wonder whether it works in practice. When economists see things working in practice, they wonder whether it works in theory! The study of the natural resource curse is a case in point. I will first look at practice around the world and see if there is a theory that we can apply to Mongolia as well.

Global examples: cases of worst practice
As we look at other countries, there is more bad practice than good. Diamonds have not made Angola rich. Oil has not delivered prosperity to Venezuela. Rich reserves of Coltan, Gold and Copper have fed war in the Democratic Republic of Congo. Or closer home in Russia, a few oligarchs have gained immense wealth, while 70 percent of Russians earn less than $380 per month. And so, the world is filled with rich lands – that have poor people. In nations like Congo, Suriname or Sierra Leone, which are dependent on the mining industry, per capita income declined by almost 11 percent in the 1990s while globally per capita income rose by 17 percent during the same period. And indeed, countries with large primary export sectors (oil, rubber, diamonds, minerals) often, though not always, grow more slowly than their peers—a phenomenon recognized in mainstream economics as the “resource curse”.

So what does this curse bring?
Many of the resource rich countries – be it oil or minerals or other precious metals – are often characterized by authoritarianism, corruption or huge military expenses like the OPEC states that spend one fifth of their national budgets on defense. The members of the oil cartel spend only half the global average on school children and students. Oxford professor and former World Bank Director, Paul Collier says that in countries that depend mainly on natural resources the probability of civil war is 23 percent against countries that don’t dispose of their natural resources where it is only half a percent. The Democratic Republic of Congo is a stark example of this. Few regions of the Earth contain as many treasures – and few are as blood drenched. The war in the eastern part of the country has cost 4 million lives since 1998.
Nigeria is another striking example. Twenty five years ago, when the country was still an important exporter of agricultural products, annual per capita income was $913. Now the 135 million people of Nigeria earn only $645 on average. They often live without electricity, without running water, without a developed road system -- even though revenues from oil have doubled during the same time period. In Nigeria today, more than 130 armed militias fight for influence. The situation here is so chaotic that Nigeria, which is the world's sixth-largest oil exporter, has to import fuel. While this is what we see in practice, what does economic theory say?

The theory of the natural resource curse
Economists Jeffrey Sachs and Andrew Warner in a series of papers (1995, 1997, and 1999) found a negative relation between resource abundance and growth in 79 resource rich countries. In other words, states rich in resources usually have considerably lower economic growth than states where natural resources play a less important role.

Why is it so? There are four major types of challenges that come with developing natural resources. And if not managed well, they can affect the country’s development in many ways. The first is vulnerability to external shocks. Many of the crises in emerging market economies result from large terms-of-trade shocks, caused by sharp falls in the prices of a countries main export commodities, and resource based economies are particularly vulnerable to this risk.

Second, developing a country’s resource sectors implies an increased risk of ‘Dutch Disease’. This term was coined to reflect what happened in the Netherlands during the 1960s – a country discovers a new commodity or resource and starts exporting it causing a rise in the exchange rate and/or the general wage levels in other sectors making the other sectors less competitive. To understand this better lets take the example of Canada. In the western part of the country, the extraction of resources, particularly oil sands, is boosting the economy. But in the traditional industrial centers, such as Ontario or Quebec, jobs are being lost. This boom in the oil industry is increasing wages in that sector, attracting labor from other industries and imposing higher wage costs on them. Truck drivers in Canada in the sector can earn as much as $100,000 per year. Such high wages push up the prices of commodities and services. The value of the Canadian dollar has increased by almost one-third with the respect to the US dollar in three years and the export economy is struggling.

Third, the challenge of governance and institution building. Governments become used to the ‘easy rents’ generated by natural resource booms, which reduce incentives for reform and diversification. The combination of abundant natural resources, undeveloped markets and lax legal structures may have quite destructive consequences. In extreme cases, civil wars break out – such as Africa’s diamond wars – which not only divert factors of production from socially productive uses but also destroy societal institutions and the rule of law.

Rent seeking can also take other forms. For example, governments may be tempted to thwart markets by granting favored enterprises or individuals privileged access to these resources, as, for example, in Russia, or they may offer tariff protection or other favors to producers at public expense, creating competition for such favors among the rent seekers. Extensive rent seeking – i.e., seeking to make money from market distortions – can breed corruption in business and government, thus distorting the allocation of resources and reducing both economic and social efficiency. Easy rents also lead to more public expenditure rather than investments.

Finally, the weakness of human capital is one of the main causes for the spread of the resource curse as a part of the institutional channel. Natural resource abundance may reduce private and public incentives to accumulate human capital due to a high level of non-wage income – e.g., dividends, social spending, and low taxes. Empirical evidence shows that, across countries, school enrolment at all levels is inversely related to natural resource abundance. There is also evidence that, across countries, public expenditures on education relative to national income, expected years of schooling and secondary-school enrolment are all negatively related to natural capital. This matters because more and better education stimulates growth. Also, resource intensive sectors in the economy absorb the bulk of the investments in the economy without creating highly skilled jobs. This is a disincentive for both private and public sectors to invest in education.

So, is the natural resource curse inevitable? Or can it be overcome?
The answer is: it depends. It depends on how well the country manages (i) its macro economy and fiscal situation, (ii) its’ tax and administration systems to manage the revenues and rents and diversify its economy, (iii) to obtain the political will to prevent corruption and wasteful spending, and (iv) to develop its human and social capital.

Avoiding boom bust cycles – managing volatility
Good macro-economic management is a must for such an economy. Here fiscal responsibility – ensuring that the budget is kept in balance, spending is minimized on recurrent expenditure, and a good deal is saved, especially when prices are high, is key. The importance of fiscal policy across the ups and downs of commodity prices, suggests that much like the herder in Mongolia who saves, and dries his curds, meat and other things in preparation of the winter, some form of a stabilization fund, that accumulates the extra revenues that come suddenly, would be important. These revenues would ideally be managed by an entity that has no authority to spend the money. The rules for when and which revenues should be accumulated and when they should be spent should be very strict and transparent. The stabilization fund can be helpful to smooth government revenues and thereby spending over the commodity price cycle. Second, it might help in smoothing growth. Because the fund accumulates money when commodity prices are high, the money can be spent in years when the prices fall. As such it can prevent the economy from overheating when it is growing very fast and provide a stimulus when it begins to slow.

Diversifying the Economy – preventing exchange rate appreciation and Dutch disease
One of the best ways of avoiding the Dutch Disease is to have a good tax regime that balances the need to tax more now v/s ensuring greater taxes in the longer run, and the need for low taxes that would result in lost revenue, v/s too high that would result in firms not complying or keeping away investors. So when direct taxation of the natural sector is increased, it allows the government to lower the overall tax levels in the economy, and in particular to cut non-wage labour costs. By taxing the resource sector heavily it decreases the wages in the resource sector and reduces the pressure on wages in other sectors, thereby allowing them to remain competitive.

The use of a stability fund, by contributing to capital outflows when prices are high and inflows when they are low can be important to counteract the current account pressure on the exchange rate and shield the economy from exchange rate fluctuations.

In addition to these there is a long list of structural reforms, including financial sector and administrative reforms that must go hand in hand with the above measures. Ensuring a good framework for the banking sector to develop, improved basic conditions for SMEs and entrepreneurs, reducing burdens caused by over regulation, corruption in the bureaucracy, can help the other sectors flourish and help diversify the economy – one important pillar to overcome the resource curse.

Building institutions – preventing capture and minimizing opportunities for corruption
Most of the above challenges of macroeconomic management and structural reforms can all be managed if there is strong political will, an effective state, and efficient administration. As such while the challenges above are ever present, both theory and practice suggest that these can be overcome. But, the most difficult is the politics and the building of institutions that can help manage these changes. Otherwise resource rents are simply divided between resource companies and their bureaucratic counterparts, with only a small share making it to the state treasury.

There are various measures that can be taken to limit corruption. The first step is to create more corruption-resistant structures. Rules if necessary at all, should be simple, transparent and standardized with few exceptions and as little reliance on bureaucratic discretion. One initiative that is being tried across the world with some success is the Extractive Industries Transparency Initiative that stipulates that those businesses active in raw materials should disclose their business dealings.

Developing human capital for long term sustainable development
However one crucial factor that is likely to determine the long run basis of growth for any economy and which will play a critical role in overcoming the curse is investment and development of human capital. As we see from several studies, intensive use of natural resources suppresses growth in sectors that need workers with a high level of human capital. The more a sector depends on human capital the more it loses out at the hands of the natural resource development. It has been seen that in the 1980s and 1990s, industrial sectors that are relatively more human capital intensive developed disproportionately slowly in countries with higher contribution of natural resource sectors to GDP.

To illustrate this, let’s look at the history of Scandinavia and Latin America. During the late nineteenth century and the early twentieth both groups of countries enjoyed similar levels of GDP per capita and both were mostly exporters of natural resources. In fact, in 1870 Finland, Norway and Sweden had respective per capita incomes of $1107, $1303 and $1664, while Argentina and Chile had $1311 and $1153 dollars per capita, respectively. However, their long run evolution was quite different. Scandinavian countries developed, while Latin American countries did not. By 1990 the divergence in income levels was striking. While Finland, Norway and Sweden had incomes per capita of $16604, $16897 and $17695 respectively, Argentina and Chile had fell far behind with $6581 and $6380 dollars. These results put forward by Bravo and Grigorio, suggest that natural resources are damaging for economic growth in countries with low levels of human capital, although there is a positive income effect. The negative effects on growth would arise by drawing resources from other economic sectors capable of generating further economic growth. The main resource that can be drawn from growth enhancing activities is human capital. Having high levels of human capital therefore may minimize this effect, and my even offset it.

Can Mongolia avoid the natural resource curse?
“The past is a source of knowledge, and the future is a source of hope. Love of the past implies faith in the future.” So, said Stephen Ambrose. To look ahead, it would be good to look at Mongolia’s past briefly to see what has shaped Mongolia today. And, one cannot look to past until one looks to the legacy of the great Khan of all: Chinggis Khan – one that has earned him a place beyond the millennium. His conquests, redefined not just Mongol history, but the world order. On today’s map Chinggis Khan’s conquests include 30 countries with over 3 billion people. As such, more than half of the world has been touched in some way by the Mongol conquests.

There are many reasons to be proud of such an individual: he liberated his country, united the people, created an alphabet, wrote the constitution, established universal religious freedom, invented new means of warfare, marched an army across continents, and opened the gates for commerce in a free trade zone that stretched across the continents. It was during his reign that he lowered taxes for everyone, abolishing them for doctors, teachers, priests, and educational institutions. He established a regular census and created the first international postal system.

As English scientist Roger Bacon observed in the thirteenth century, the Mongols succeeded not merely from martial superiority; rather, “they have succeeded by means of science”. Seemingly every aspect of European life – technology, warfare, clothing, commerce, food, art, literature, and music – changed during the Renaissance as a result of Mongol influence. With so many accomplishments it is not a surprise that Geoffrey Chaucer, among the greatest of the early authors in the English language, devoted the longest story in the Canterbury Tales to Genghis Khan. He wrote in complete awe and admiration of his accomplishments.

So, can a people that managed all these things, almost eight hundred years ago, not manage to overcome the resource curse? I am sure they can, but in doing so they will have to build even better rules, administration, justice, and most importantly, their education and scientific base. In short invest in people. For, a new tomorrow is filled with hope and promise – and fraught with dangers as well.

I leave you to decide whether the natural resources of this country will be a blessing or a curse. I hope personally though, that they will be a blessing.