Resource curses

The puzzling phenomenon of the “natural resource curse” underlies discussion of extractive industries. Countries such as Congo (rich in an array of minerals) and Venezuela (oil) that export natural resources have been outperformed economically (and politically) for decades by resource-poor jurisdictions such as Cayman, Singapore and South Korea that import minerals and oil. 

All that glitters… 

Sitting on a gold mine or pool of oil would seem a sure way to national wealth, but the economic development literature provides evidence that many countries with valuable natural resources suffer from low growth rates, low income and poor quality of life. Prominent economists such as Jeffrey Sachs showed empirically that controlling for other attributes of an economy, reliance on oil and minerals is related to low rates of growth.

Controlling for other geographical and climate variables, resource-poor countries enjoyed higher rates of growth than their resource-rich counterparts. Resource wealth has also been shown to increase the likelihood of domestic violence as factions fight for control of assets. On the other hand, Cayman, Singapore and Hong Kong are relatively barren, but enjoyed growth, stability and improved quality of life.

Correlation is not, of course, causation. Oil has been good to Norway and Alaska. There are examples that both illustrate and contradict the resource curse hypothesis.

While the Congo, rich in diamonds and other resources, has been a sad story for a long time, Botswana, also diamond rich, has performed better than other resource rich African nations. Some empirical work has been critical of the resource curse findings, including one statistical study finding that resource wealth is beneficial in some East Asia and Latin American countries.

It would be fair to say, however, that more often than not, oil and mineral wealth has been associated with a lack of economic development and personal freedom rather than a key to prosperity.

There is not a dominant explanation for why this is so. Most analyses suggest it is related to the quality of governance and property rights institutions. Some studies have tried to measure the rule of law, finding that weak institutions mean a lack of constraints on plundering by the ruling class. In many nations, the generation of wealth from resources does not help to create better institutions. Some analyses suggest that natural resources increase costly internal struggles for control.

Destructive rent seeking 

Growth in a country likely requires reinvestment of rents in markets, not politics. Rent is an economic term of art meaning profits greater than are needed to sustain a particular activity. Rents create opportunities for political exploitation because a certain level of income can be extracted without destroying the activity that generates the income (although at the extreme, as in Venezuela, the income generator itself can be debilitated by inept governance).

In resource rich countries, rents from resources are often used in political contests for control by the ruling class. They are not invested in wealth-creating activities that may boost the larger economy over time.

Not surprisingly, resource rich countries often suffer under authoritarian governments and from internal conflict. Historically, economies that relied on extraction and exports from minerals or plantation crops were more likely to develop slavery, dictatorships, and state control. The ill effects of such institutions could be long lasting, especially in locales that still rely on extraction for exports.

Natural resource wealth also appears to be related to other economic problems. The level of inequality is higher and labor allocation may be less efficient. The income from natural resource development may cause “Dutch disease,” named for the impact of natural gas revenue in the Netherlands in the 1950s.

The economic effect of a boom (or bust) in revenue from an exported commodity can increase (or decrease) the value of a nation’s currency through exchange rate effects, distorting the economy.

A boom in government revenue from export fees or royalties from sales can also cause distortions. If governments fail to adjust to the cyclical consequences of fluctuations in commodity prices, they are unprepared for the collapse of revenues when prices drop. Boom and bust, rather than a careful management of added revenues during boom times, then contributes to economic and political instability, as seen in Venezuela among other jurisdictions.

The curse of corruption 

Trying to root out corruption – the theft of natural resource income ─ is extraordinarily difficult. Attempts to do so have not been fruitful. In 2000 the World Bank pressed Chad, ranked one of the most corrupt nations by Transparency International, to take steps to avoid the resource curse problem as a condition for funding for an oil pipeline.

The agreed solution was for ExxonMobil to deposit oil revenues in an escrow account at Citibank. An independent committee would oversee spending to ensure that most oil money went for poverty-reduction measures that benefitted ordinary citizens. Once the oil revenue began to arrive in 2005, Chad reneged. Nigeria committed to a similar program in 2004, effected through legislation in 2007. In practice little changed.

The problem with this type of “solution” is that, unless governments can bind themselves and their successors, plans intended to block non-beneficial use of public revenue are not enforceable. Well-financed sinners have little incentive to comply with the desires of well-meaning preachers of good government.

No doubt greater transparency is beneficial, but even if governments go though the motions of committing to such programs, making sure the numbers reported are accurate is a significant challenge. Bogus numbers shine little light on how funds are actually used.

If multinationals insist on integrity in accounting where they operate, corrupt governments are more likely to sign contracts with state-owned enterprises not burdened by measures such as the U.S. Foreign Corrupt Practices Act. China has rapidly become the leading investor in African, Venezuela and other Latin American oil and minerals concessions not solely due to the expertise of Chinese oil and mineral engineers.

Offshore financial centers 

When oil was discovered in Venezuela in the early 20th century, the Anglo-Dutch refiner Royal Dutch/Shell was eager to exploit the oil field but reluctant build an expensive refinery operation in unstable Venezuela.

Close to the Venezuelan coast, the islands of Curacao and Aruba offered natural harbors and the stability of Dutch law. Oil companies such as Royal Dutch/Shell built their refineries on those islands and brought crude oil from Venezuelan fields to the islands that housed their legal home. This arrangement necessitated the development of a professional workforce of accountants, lawyers and notaries (an important profession in civil law systems such as the Netherlands) to help administer the refining companies and the other firms that grew up around them.

During World War II the Netherlands Antilles served as the home of many Dutch interests to protect them from the Nazis. After the war, the legal infrastructure stayed in place and the Antilles became a preferred low-tax jurisdiction with competent government.

The United States effectively killed the Antilles as an offshore locale, but the model was established.

Other jurisdictions developed niches in financial services. In the Western Hemisphere, Bermuda developed as a center for insurance companies and reinsurance companies; the Caymans created banking and trust laws that drew business; the Bahamas developed an extensive offshore banking business.

In Asia, Hong Kong and Singapore developed roles as financial centers. In Europe, Guernsey, Jersey, the Isle of Man, Luxembourg, Lichtenstein, Gibraltar, Malta, Switzerland, Andorra, and others developed financial sectors. Delaware is the home of superior corporation law and legal services in the United States. These are small jurisdictions with few natural resources and small labor forces.

Why do small jurisdictions often have such a niche? If a large country were to renege on the quality of its financial rules it would suffer damage that would have minimal impact on government revenue. If a small country such as Luxembourg were to do so, the damage would be severe.

This “bonding” effect means that smaller jurisdictions can do a better job of credibly committing to maintaining a stable corporate law regime. Further, given the importance of the financial industry to their economies, the legislatures in smaller jurisdictions are much more likely to pay attention to needed changes in the law that are responsive to changes in technology and business organizations.

While some corrupt countries, such as Antigua, become involved in financial services, they do not become major players and often have short lives in that market. More honest regimes attract business over the longer term; Luxembourg is stable and honest.

Cayman’s regulatory efforts are far from perfect. The government has made missteps and the islands face challenges today. What is remarkable is the degree to which Cayman has avoided wrecking its financial sector while growing to be the fifth largest financial center in the world economy.

This success is due to a remarkable record of value-added regulation, in which the Islands have competed for business by enhancing the rule of law and by crafting regulations that promote transactions rather than impede them.

Citizens of Cayman may wish to celebrate the lack of a huge oil pool that Venezuela “enjoys.” Searching for something more to do than fishing gave Cayman residents an incentive to develop quality financial services that will evaporate should the government become rapacious as often happens in resource rich countries.