All Is Not Gold That Glitters

1. Exposure to External Conditions
The country’s income related to increase of the oil prices cannot be viewed as stable. Volatility of oil prices is always high; events that are not directly linked with economy can changes their level radically. As a result, even such fundamental indicator of the national economy condition as per capita gross domestic product is fluctuating in an unusually wide range.
So an important task for the authorities of oil producing countries is not to allow a situation when fulfillment of budget obligations and maintaining financial stability depend on the dynamics of a parameter which is hard to predict, especially as such parameters can hardly be managed. When the market conditions are favourable and the countries exporting hydrocarbon products have access to international financial markets, they frequently attract external loans, try to foster development of economy on this basis, and begin to implement large-scale investment projects. When the market conditions change, the credit resources that had recently been so accessible and easy become extremely expensive and sometimes are completely unavailable. It is impossible to refund the old loans at the expense of new ones. So the borrowed money has to be returned from the budget whose income has dropped with the landslide of prices. As a result the county may face a budget crisis, problems in the payment balance, reduction of currency reserves, and inability to serve and repay the external debt. There are plenty of examples of such scenarios in the world history.

2. Loss of Competitiveness
Oil export is objectively more favourable for import of other goods rather than export. The matter is that rental income of raw material industries stimulates the growth of salaries and costs in other sectors of economy (statistical dependence of the national price level on the resources has been well proved). The sectors whose products and services face international competition become noncompetitive both in the domestic and foreign markets are forced to reduce production. Excess income of the country obtained from sale of raw materials does not encourage positive changes either since their economic development is essentially different from the European or Asian models. In fact, such country sells its resources by using them in order to «purchase» modern facilities: new villas, golf clubs, valuables, etc. However, the society remains undeveloped, and the business community is not autonomous from the state but fully dependent on it. The result is that the economic growth, especially its qualitative characteristic, is hampered.
In their book «Abundance of Natural Resources and Economic Growth» economists Geoffrey Sucks and Andrew Warner analyzed the situation in 97 countries of the world within the period of 1971-1989 and came to a conclusion that there is direct interdependence between raw materials inventory and the rate of economic growth. The richer the country in mineral, natural and agricultural resources, the slower is the rate of its economic growth. Contrariwise, the countries that practically didn’t have any resources were growing faster.

3. Human Resources Devaluation 
Availability of rich natural resources in this or that country significantly decreases their interest in the “human capital”. The number of unemployed is growing in non-raw material industriesпо due to their low competitive ability and expensive life with comparatively low remuneration of labor. The outflow of highly-qualified staff is obvious. A characteristic feature of such countries is insignificant attention to development of the education system. The reasons are not apparent but many researchers explain this by peculiarity of work force demand by mining companies. Perhaps another explanation is based on psychological characteristics of elite emerging in these countries. The Russian writer Saltykov-Schedrin wrote that timeservers do not think about the future and education means investment in the future. Thus, for example, in Saudi Arabia that has the largest oil reserves in the world the level of literacy is only 62 per cent, in other «oil Eldorado» – Kuwait, Qatar and United Arab Emirates it reaches 80 per cent while in Thailand or Philippines the number of literate people exceeds 95 per cent. In America, European Union countries and most Asian countries it is equal to 100 per cent.

4. Democracy Building Hardships
The countries whose budget is based on taxes collected from raw material exporters often have less democratic political systems and less developed instruments of civil society. This may be explained by the fact that control over extraction and transportation of minerals is focused in a handful of large companies that are in most cases linked with the government. The managers of these organizations inevitably obtain huge influence in the political world. Such distribution of roles gives rise to corruption: oil magnates insist on taking decisions that are most favourable to them and that frequently make a negative impact on other economy sectors which do not possess such powerful resources and leverage. Furthermore, availability of vast raw material resources, as a rule, does not have a beneficial effect on the state of the extractive industry: managers of these firms or the government prefer to gain profit as soon as possible instead of making long-term investments taking into account the income that will be received in decades.
True, there are some countries rich in natural resources that have created democratic conditions for their taxpayers which have gradually been transformed into democracy of universal suffrage with efficient, slightly corrupted bureaucracies. The US, Canada, Australia, and Norway are bright examples. However, these are the countries in which democratic mechanisms have been developing for centuries, and which have established efficient and sustainable institutions that can meet the challenge of rich resource environment. There are also countries that do not have a long democratic tradition and yet managed to control their resources efficiently (Botswana, Chili, Malaysia, Mauritius). Nonetheless, experience shows that creation of democratic institutes in the countries with significant role of natural rent is harder than in the countries in which this risk factor does not exist.
Excess income gained from oil is spent by the ruling groups on the programs aimed at strengthening of their power. For example, the oil boom that burst out in Mexico in the 1970s in fact created the conditions for one party to rule the country for many years. The huge funds received in the 1990s by the Republic of Congo through the sale of minerals were first of all spent on creation and outfit of the army and presidential guard. The authorities are also spending enormous sums on preventing the establishment of social groups that may become independent: similar processes could be observed in Algeria, Libya, Tunisia, and Iran.

5. Base for Corruption
Owing to privatization of the largest oil companies the officials obtain control over these companies. However, this does not decrease the lobbying opportunities of oil giants, the methods they use or the degree of bureaucratic machinery’s corruptness. In some cases, however, the operating efficiency of many nationalized companies drops considerably. Privatization cannot guarantee success either if the country does not have independent and efficient judicial and tax authorities.
Michael Ross, Professor of Princeton University, calls such countries «rentier states» using the term which in early ХХ century was used to designate West-European powers which extended loans to other governments and bourgeoisie that purchased the shares of foreign enterprises and debt liabilities of other countries. He analyzed the information on 113 countries of the world for the period of 1971-1997 in order to identify interdependency between the amount of oil and the system of government. For example, among the countries regarded by him as rentier states that mainly exist due to export of oil are the Gulf monarchies, Nigeria and Venezuela. All these countries have authoritarian regimes which results in an extremely high level of corruption, family and clan ties. The economies in these countries are in fact specializing on servicing the oil industries while advanced technology industries are developing quite slowly.
Distribution of profit generated in the economies of the countries rich in natural resources depends, first of all, on discretionary decisions taken by the authorities. This encourages the final competition not in terms of who will produce more high-quality goods at minimum cost, but in terms of the ability to bribe officials, i.e. increase in what А. Kruger called “administrative rent” in her classical work.

6. Ecological harm
Development of oil deposits usually followed up by pollutions in the environment. This is especially true for developing countries in which leading oil extracting companies do not burden themselves following strict ecological norms. There are many examples of this issue in Kazakhstan: we already have scaring tendency when hundreds of seals and thousands of sturgeons are dying in Caspian Sea because of the drilling works, in overall irretrievable harm is done to general flora and fauna. Only “Tengizchevroil” collected more than 10 mln. tons of sulfur kept outside polluting not only air but subsoil waters as well.  

7. Vein for Bureaucracy
The excess income gained from the sale of oil, gas and other natural resources which are highly quoted in the world market, inevitably results in unprecedented increase in the number of civil servants. The oil countries, as a rule, prefer not to save on bureaucrats. There are several reasons for this. First of all, the clan and family character of oil regimes in which it is popular to assign official posts to their relatives. The authorities often regard bureaucracy, army and special services as the only support of their regime. Moreover, the bureaucratic systems of oil countries, as a rule, operate inefficiently due to being corrupted, and in most cases it is quite difficult to hold an official to account for the crime he has committed. The states receive a lion share of the budget income gained from taxation of extractive industries; therefore, the civil taxes are quite low and are collected in a “slipshod manner”. This system does not encourage the population to actively influence their authorities because, unlike the states imposing high personal taxes, the taxpayers here do not worry about how their money is spent by the authorities.
The population in the countries rich in natural resources always has fewer chances to create a policy of checks and balances, reliable institutes that would restrict arbitrary decisions taken by officials, than in the countries deprived of such resources.
The quality assessments of national institutes made by international organizations are subjective. However, they all reveal strong negative correlation dependence between the indicators of political liberties, civil rights, the quality of bureaucratic machinery, the common practices of law application, on the one hand, and natural resources, on the other.
8. Lack of Transparency
Transparent information on the profit received and reporting standards is a key to efficient management of natural resources, - states Josef Shtiglits, the Nobel Prize Laureate, Professor of Economy and Finance at Columbian University. – The national accounting standards that do not reflect the activities pertaining to resource depletion are ineffective. They make the government think that economy is growing richer though in fact it becomes poor. And inadequate interpretation of the state of economy results in taking incorrect decisions. Even in highly developed countries large oil companies tried to reduce royalty payments by understating the actual oil prices and overstating expenditure. Such actions were detected only through thorough investigation. For instance, in Alaska the oil companies agreed to pay over 1 billion US dollars by order of the court only.

9. Over valued national Currency
A large flow of foreign currency received from the export of oil creates the demand for the national currency of the country and raises its exchange rate. As a result, the goods produced in these countries become more expensive and less competitive both in the domestic and foreign markets. This, in its turn, leads to stagnation in the agricultural, industrial and other sectors of the country’s economy, as well as to job destruction in these sectors and increasing dependence of economy on the oil-and-gas sector. Development of the oil-and-gas sector also stimulates monopolization of the existing investment funds which results in increase in cost and decrease in the volume of loans aimed at developing other sectors of economy. This syndrome made a profound impact on Holland in the 1970s. At that time the profits gained by the Dutch companies from export of oil grew rapidly which encouraged the inflow of currency into the country that was sold by exporters in the domestic market. Excessive supply of foreign currency resulted in considerable increase in the national currency (guilder) rate. So many local goods became much more expensive and lost their competitive ability. This ruined the majority of processing industries in the country. Australia and Mexico had a similar experience.

10. Risk of Destabilization
Finally, the sole orientation of this or that country’s economy on the sale of oil or other raw materials poses a high risk of internal destabilization. German economists Paul Caller and Anke Heffler found that in the countries that have one or two basic resources used as the main export article (e.g., oil, gas, diamonds or cocoa) the probability of a civil war is five times higher than in the countries with diversified economies.
The risk of political instability is also intensified by the struggle – often concealed from public – for redistribution of rent profit both within the country and in its relationships with foreign extractive companies.
In the event of financial crises or a sharp decline in prices for hydrocarbons, the transition from the environment accustomed to high prices for the exported raw materials to tough economy is not easy. In many case it results in the changing the political regime. This may happen in different ways: political liberalization in Mexico, military coup in Nigeria, civil war in Algeria, democratic crisis in Venezuela. And, after all, the oil reserves may become the reason that causes direct aggression from abroad as in the case with Iraq.

What to Do?
It becomes quite clear that the strategic focus of the economy on production of natural resources has little prospects. These rich resources can produce a desirable effect only if they are used as a springboard for the growth of other sectors of economy, and involvement of advanced technologies.   
Perhaps one exception to this rule is Norway which started a large-scale oil production in the Northern Sea in the 1970s. The oil boom began in Norway when the country already had well-developed economy and powerful democratic institutes. Therefore, the society managed to establish efficient control over excess income gained from the sale of oil, and the government is trying to encourage development of other sectors of economy, thus preparing for the moment when the oil and gas reserves become depleted. Among the other rare examples of countries whose proceeds from export of raw materials enabled them to achieve progress in economy are some Arab monarchies, particularly the United Arab Emirates, Qatar and Kuwait. But there are some things to mention here: first of all, they have all established 100 per cent control over the domestic oil industry and developed the associated industries such as oil processing and petrochemisty; second, they have invested considerable funds in the development of such fields of economy as advanced technology production, international trade, tourism, construction industry; third, they have succeeded in eliminating corruption and the bulk of other seamy sides of authoritarian regimes. Finally, these counties have very small population which enables the local authorities to meet the social and economic demands of their citizens and spend a lion share of their “petrodollars” on enhancing competitive ability of their countries.   
Risk hedging, entering into forward agreements is another possible solution to the problem, reasonable from the economic perspective but dangerous from the political point of view. If the dynamics of prices proves to be more favourable than the one stipulated by the forward agreements, it will be difficult to explain to the population why the budget has incurred losses. There will always be those who are willing to prove that the transactions had been deliberately harmful fro national economy. This does not mean that such problems are unsolvable. The most common measures aimed at their settlement include the establishment of stabilization funds replenished during the favorable market conditions.