The resource curse typically describes the apparent relationship between the increase in a country’s exploitation of natural resources and a decline in the manufacturing or agricultural sector of an economy.
An abundance of natural resource wealth can also distort economies in a number of other ways. Private investment in other less exploitable/profitable sectors of the economy may stagnate, leaving the government and economy highly dependent on resource revenues. This may be okay when commodity prices are high, but if they decline or suffer high volatility, and the economy is reliant on one commodity, then the economy becomes very vulnerable.
The commodity bust since 2011 exposed deep-seated problems that were covered up during the boom, as governments and citizens expected the good times to carry on. Over-optimism about Chinese commodity demand caused unneeded investments to be made in many emerging economies that fed the commodity boom and political corruption that only led to even worse capital mis-allocation.
A further problem is the potentially corrosive effect of commodity production on political institutions. Many commodities incorporate rents (ie, excess profits derived from the fact that supply is usually limited in the short term). Given that many commodity producers are owned and managed by the government, it is in the state’s interest to capture those rents, but corruption often follows when it does.
The danger is that once commodity prices fall it can leave economies dangerously exposed. Whole countries can become “white elephants”.
Even the expectation of a resource boom can lead to some of the problems associated with the “resource curse”, even if not a single mineral is actually extracted. Researchers from Oxford University found that the mere expectation of future natural resource booms in São Tomé e Príncipe and Madagascar led to “resource curse” effects, even though neither country actually experienced the expected boom. Both countries experienced significantly more volatile economic growth and eroded political governance.
What role do unrealistic expectations have in aggravating the effects of the “resource curse”? Well, first the mere expectation of a commodity boom can increase corruption and can lead to a change in the allocation of public resources. Over-optimistic price expectations only make the necessary adjustment to public finances that bit more painful. Terry-Lynn Karl and Ian Gary from the Institute of Policy Studies asserted that “oil booms raise expectations and increase appetites for spending” and that, as a result, “governments dramatically increase public spending based on unrealistic revenue projections”.
Secondly, expectations of future resource revenues from commodities can cause economic effects, such as changes in the real exchange rate that adversely affect the manufacturing and service sectors. Richard Auty of Lancaster University pointed out that the neglect of non-resource sectors resulted “in part from over-optimistic expectations for both mineral prices and RBI [resource-based industry] output”. Furthermore, unmatched expectations of higher personal incomes among the population can cause popular discontent and lead to societal conflicts. As Gisa Weszkalnys from the London School of Economics notes in reference to an oil boom, “occasionally, it is thought to be just the expectation of oil that causes the curse to happen”.
The highest profile country that has suffered the most since the commodity bust has been Brazil. Yet Brazil was the first letter of the moniker BRICs, popularised by Goldman Sachs to represent some of the major emerging economies of the early 2000s. Not long ago, Brazil stood as the leading example of how a developing nation could rise toward global prominence on the back of a China-driven commodity boom. As its economy surged, Brazil stormed the world stage – hosting a World Cup, demanding more say at the United Nations and blocking a US free-trade plan for the Americas and hosting the Olympics. Now Brazil is looking like a symbol of something else: resource-rich nations have a habit of ending their booms with spectacular busts.
Looking back, it is easy to understand the frenzy of optimism. If the biggest economic story this century was China’s rise, Brazil was uniquely poised to benefit from it. Rich in iron ore, soybeans, beef and oil, Brazil was positioned as a supplier of many of the things that China desperately needed. Its annual trade with China soared from $2 billion in 2000 to $83 billion in 2013, supplanting the US as Brazil’s largest trading partner.
China’s rise helped spur global investors to pour more than $1 trillion a year into emerging markets by 2011, a five-fold increase in a decade. Brazil was a leading destination. Its securities markets were more transparent than China’s, therefore some investors bought Brazil as way to play China.
Jim O’Neil recognised the potential for problems in the first letter of BRICs in his book “The Growth Map”:
These days I do worry that Brazil might be partially suffering from the so-called “Dutch disease” [so called after the Netherlands experienced a decline in its manufacturing sector after gas was discovered]. As a result of the country’s richness in commodity wealth, and with its high interest rates, the currency might have risen too far too fast, and this may damage the manufacturing part of the economy.
O’Neil went on to say:
In mid-2011, Brazil possibly has the most overvalued currency of the BRIC’s. In the long term, I remain extremely optimistic about Brazil, and its recent success after decades of economic failure, are grounds for great hope. In the shorter term, I suspect that the strength of the real will be problematical.
Commodity prices then began to decline in early 2011 and like the tide retreating from the shore left Brazil without its proverbial bathing gown. Brazil’s economic decline is partly due to the fall in commodity prices, but partly due to the build up of liabilities and the mismanagement built on the premise that revenues from commodities would continue to rise and Brazil’s economic growth would remain strong. In turn, this was used to justify the government’s fiscal largess in terms of public spending commitments.
Brazil turned itself into an expensive place to do business. A complex tax system, over generous pensions, poor transport infrastructure, high wages relative to its competitors and pointless regulation. In dollar terms, movies and taxis in downtown São Paulo were more expensive than in New York. The country’s intoxication with its commodity boom with China also helped to turbo-charge many other unhealthy practices. From corruption to bribery, the intoxication eventually claimed the head of Ms Rouseff, Brazil’s president, accused of corruption and mismanagement.
Even resource companies most exposed to the country were in denial over the extent of the problem. “In the corporate world, you spend half your life making forecasts and the other half explaining why that forecast was wrong.” That was Vale’s ferrous-division director, José Carlos Martins, who in mid-2014 kept telling investors that iron ore prices would remain high even as they kept on falling.
It’s worth noting that while the Goldman Sachs paper from 2003, “Dreaming with BRICs: The Path to 2050”, sets out the economic rationale for why the five members of the group are included, it does not include a single mention of the role that commodity prices could have in binding their relationship together. It also does not mention the risk that a fall in commodity prices could have on the performance of Brazil or any of the other countries, or the risk that resources could be mismanaged. Indeed as soon as Brazil and the other members of the BRICs became tainted, or at least lost some of their shine, the search was on for another group of even more emerging economies upon which the growth of the global economy and rising demand for commodities would be based.
Brazil, according to an old joke is “…the country of the future—and always will be.”
Another example of a country that rode on China’s economic coattails was Mongolia. During the commodity super-cycle that peaked in 2011, Mongolia had an epic run. Stoked by a booming Chinese economy and brisk foreign direct investment flows, Mongolia was one of the fastest-growing economies in the decade that ended in 2015. Its economy clocked in with an average real GDP growth rate of 8%, while per capita income surged to about $4,000.
The country of roughly 3 million people is blessed with abundant natural resources (estimated by the International Monetary Fund to be valued at somewhere between $1–$3 trillion in 2011), and so attracted billions of dollars in mining investment. According to The World Bank, Mongolia was “at the threshold of a major transformation driven by the exploitation of its vast mineral resources.”
It all went bad when China’s growth throttled back from double-digit levels in 2011, just as the Mongolian government went on a debt-fuelled spending binge. Then, in August 2016, came the collapse of the currency, the tugrik. Construction groups, thought to have borrowed heavily from abroad and in particular from China, were now saddled with much higher debts with no way of paying them off.
The authorities were also stuck in a similar position, having borrowed heavily on the back of the boom in commodity prices. Foreign exchange reserves tumbled to $1.3 billion by mid-2016, a 23% decline from a year earlier. Steep salary cuts of up to 60% were forced on some staff on the state payroll. The debt-fuelled binge also extended to individual families and communities too, with workers borrowing heavily against their salaries and pensions and contributing to a boom in demand for upmarket foreign cars and other luxuries.
Although I have some sympathy for Marc Faber’s point that investment manias are an integral part of capitalism, I would prefer my money is not on the line when an investment turns sour. I hope it is not your money either. Unfortunately, as night follows day examples of capital misallocation from the dairy, minor metals and petrochemical industries and those economies most exposed to Chinese demand for commodities will not be the last. As an investor, you may not be totally dependent on the outlook for commodity prices. However, for many individuals, communities, and even whole countries their futures may turn decidedly bleak if commodity markets turn against them.