Countries that are rich in natural resources seem to suffer from recurring economic vulnerability, internal conflicts, bad governance, failure to plan for the longer term and overall neglect over the general population. This is known as the “resource curse”, or “the paradox of the plenty”, of oil producing economies, which performance is closely correlated to the oil price. This “curse” is seen as an obstacle to progress in developing economies. Historically speaking, countries that rely almost exclusively on oil exports for development tend to share some negative adverse effects, namely: slower than expected growth, weak economic diversification, high levels of corruption high levels of income inequality and poverty, poor governance, and a high frequency of internal conflicts and wars. If we look at Angola, as an example, despite being the 10th largest oil exporter in the world, it was considered the deadliest country for newborns in the world just five years ago. Trying to find an empirical reason to justify why these economies appear to fail overtime is subject to debate. However, political failure and growth collapse seem to be present in almost every economy subject to the resource curse. The four main factors that explain the negative impact this has on growth are:
- Oil price volatility: The international oil market is probably one of the most volatile in the world, making long term planning difficult.
- Failure to compete, also known as the “Dutch disease”: Occurs when the oil industry causes a rise in the exchange rate of the local currency, making other exports noncompetitive, which disincentives other industries to grow, and therefore further increases the dependency on oil exports. It also encourages amore import led economy, as foreign goods become cheaper. This, however, does not lead to a more diversified and sustainable economy, capable of thriving beyond the oil sector.
- Lack of skills and performance quality: It is worth mentioning that the majority of the poor oil producing nations are weak states, with many of them only becoming independent until late19th century.
This means that the governments of these countries have not had the time to build strong institutions which are pivotal to this sector in particular. A clear example of this can be found in the Algerian oil company Sonatrach, which has had nine different CEO’s in the past decade, adding uncertainty and insecurity to the market.
SEVERAL TAX CHANGES OVER A SHORT PERIOD OF TIME CREATE A LACK OF TRACK RECORD TO UNDERSTAND HOW THE LAW SHOULD BE APPLIED.
- Taxes, fiscal insecurity and management of revenues: Generally speaking, a government that relies almost exclusively on oil revenues does not feel the need to develop a very complex tax structure since most of its revenue comes from the oil sector. An example of this is Angola, which up until 2019 did not have VAT and only now felt the need to implement it and to diversify the source of tax revenue in the economy. As to what concerns fiscal uncertainty in many developing nations, the main issues are the way in which the nation’s fiscal authority interprets and applies the law, which is not very coherent nor straightforward. Additionally, several tax changes over a short period of time create a lack of track record to understand how the law should be applied. Therefore, for investors, these factors create a great deal of uncertainty and can act as a barrier to entry.
Consequently, after the decline of oil prices in 2014, these economies were forced to adapt to a new reality and to diversify their economy, in order to reduce exposure to a single commodity. In the meantime, however, this has caused several countries to enter into deep economic and social crisis, with the most extreme example being Venezuela. Again, this crisis that a lot of developing nations are going through at the moment, share three things in common. Their currency has depreciated against the US Dollar, they have low tax reserves and their fiscal revenues are almost all linked to the oil industry.
No sustainable economic development under these circumstances can be sought if the institution that is attempting to boost it is of a deficient nature and does not act in the best interest of the nation. Tackling this “curse” is a very complex and difficult issue, and there is no doubt that needed changes and reforms must come from within, if they wish to have any meaningful impact. Putting a stop to corruption is a very difficult issue and might be seen as unrealistic in some cases. However, it does not go without saying that the transnational oil corporations that operate in these nations need to focus on corporate social responsibility, and profit expatriation is not the solution to this. Other solutions, that aim to mitigate the Dutch disease, focus on holding revenues in a sovereign wealth fund, which again is not effective if governmental institutions are of a corrupt nature.
All in all, when considering investing in a developing nation, higher risks must always be taken into account. Moreover, if it is a developing nation that is almost exclusively focused on oil production, there source curse must be considered and possibly used as an outline for evaluating whether the nation has the necessary conditions and infrastructure, to be regarded as attractive for investment.
Article published in our February Newsletter
Rodrigo Marques, MSc in Finance