To understand why, in the case of most countries, stronger linkages with the rest of the economy have not emerged over time, it is necessary to look at how and at what speed the sector developed as well as at the resources produced.
There is a strong tendency among countries that discover resources to develop projects as quickly as possible and aim for rapid depletion of those resources. Pressure to do so comes from two sources: the host government and the operating companies.
Pressure on Government to go Fast
Announcements of commercial discoveries of oil, gas and/or minerals inevitably raise expectations among the population. This means that governments are immediately under pressure to deploy revenue quickly. At the same time, governments see the inflow of revenue as a means of solving various macroeconomic problems and thus, of helping them to be re-elected. Hence, Guyana must avoid being a country of kleptocracy, where rapid revenue inflows create a pot of money to be raided as quickly as possible.
Companies Tend to Prefer Fast Development
The long-held view among extractive companies is that the sooner and faster the resource is produced, the better the project economics will be. The logic behind that view derives from the economics of discounted cash flow associated with any project: the assumption is that, as long as gross inflation is not expected, future revenue will be worth less than present revenue. Thus, other things being equal, early oil will increase the net present value of the project and hence its economic attractiveness.
The Role of the Shareholders
Key in this context is the role of shareholders and financial markets – not only in setting the cost of capital, but in demanding visible near-term returns. Ever since the early 1990s, when the international oil companies adopted a financial strategy based on maximizing shareholder value, they have been under constantly increasing pressure to deliver shareholder value through either higher dividends or higher share prices. This has tended to encourage rapid development of natural resources in a financial market where short-termism has become increasingly dominant, especially since the financial collapse of 2008 (Stevens et al. 2015).
At the same time, the infrastructure needs of the oil and gas industry favour large technical economies of scale. Basically, the more that is produced, the lower the cost of production, processing and delivery. In the case of pipelines and storage tanks, for example, the relationship between surface area and capacity is exponential: doubling the size of a tank in effect halves the average cost of storage. This means that pipelines and tanks need to be as large as possible. However, it also means that they need to operate as close to capacity as possible, otherwise the very large fixed costs are spread across a smaller throughput and average costs rise, damaging profitability at an exponential rate. Both higher net present value and the economies of scale associated with infrastructure are the reasons why in the past companies have invariably pushed for rapid development.
In theory, the rapid development model offers advantages in terms of cash with which to solve immediate and urgent problems in an economy – such as poverty reduction, debt financing and energy and transport infrastructure needs. At the same time, it is in harmony with the idea of a ‘one-off’ opportunity for development in a volatile market, especially when there are concerns that the resources may not be worth as much in the future.
The Development Agenda
For their part, multilateral financiers and development agencies have been eager to apply their expertise to the extractives-led growth agenda. There has been strong interest in delivering a ‘win-win’ situation in which countries can be brought out of poverty while supplies to the market are increased and financing from large corporates and their governments is secured. This is nothing new in the history of development aid and advice since the 1950s. Each such institution has its own credo, its own rules of engagement and its own manual offering advice. Every time its advice is put into practice, it sees its influence increase.
However, this approach has resulted in an outcome that was not the intention of many of the advisory agencies. In terms of practical policy and economic advice, the extractives-led growth agenda has tended to reinforce domestic, government and investor pressures to ‘develop fast’ and, as a result, become indebted.
However, developing projects as fast as possible and aiming for a rapid rate of resource depletion poses several problems, especially for developing countries that have limited institutional and regulatory capacity:
- Unless already highly developed, the local private sector may have neither the time nor the means with which to develop the capacity needed to help take advantage of the linkages from natural resource projects. Indeed, it is telling that even Norway – one of the highest-capacity producers and frequently cited as ‘the model’ of good governance – chose to develop its oil sector at a relatively slow rate in order to allow time for the development of backward linkages.
- The time available may be insufficient for the government to develop the institutional capacity required to enforce the regulation of the new sector, which may be strict, or to provide the necessary governance and mechanisms to handle the new revenue flow.
- In the case of oil and gas, rapid increases in supply as a result of rapid development of projects will lead to public pressure encouraging the use of those fuels for domestic energy at prices much lower than their export value and without taxation to mitigate their negative environmental impact. The effect is to lock in both subsidies and trends towards decreasing air quality and increasing emissions.
- The above factors combined with large revenues (relative to the rest of the economy) flowing to government are likely to result in unsustainable spending patterns and many of the ills described in the resource-curse literature. In such a case, the prospect is that the country will become increasingly indebted once export capacity begins to wane.
Harnessing Natural Resource Windfalls
Despite the normative and political analyses of converting depleting natural resources into productive assets, there are good technical reasons to pump oil as fast as possible out of the ground once a field has been opened. So, it may be better to focus at the optimal way of harnessing a given windfall (Collier et al. 2010). Such windfalls are typically anticipated (five years or so) and temporary (say twenty years). The benchmark for harnessing such a windfall is based on the permanent income hypothesis, which says that countries should borrow ahead of the windfall, pay back incurred debt, and build up sovereign wealth during the windfall and finance the permanent increase in consumption out of the interest on the accumulated sovereign wealth after the windfall has ceased. Indeed, the International Monetary Fund (IMF) has often recommended resource rich countries to put their windfalls in a sovereign wealth fund (Davis et al. 2001). The permanent income hypothesis and the consequent building up of such a fund are used to optimally harness unanticipated windfalls. In practice countries such as Norway prefer to restrict incremental consumption to interest earned on the fund and not to use the windfall until it is banked, which gives the conservative bird-in-hand rule.
Therefore, for an economy such as Guyana the estimation of fiscal reaction functions for non-hydrocarbon tax and public spending using official projections for hydrocarbon revenues and the pension burden may suggests that fiscal reactions have to be partially forward-looking with respect to the pension bill, but indeed not with respect to hydrocarbon revenues (Harding and van der Ploeg 2009). The primary non hydrocarbon deficit should according to the permanent income hypothesis react only to permanent oil/gas revenues, but in practice it also reacts to current revenues.
As such, one must take account of the special features of resource rich developing countries. Many countries such as Guyana have been converging on a development path, suffer capital scarcity and high interest rates resulting from premium on high levels of foreign debt, and households do not have access to perfect capital markets. In that case, the permanent income hypothesis is inappropriate. In contrast to transferring much of the increment to future generations (as with the permanent-income and bird-in-hand rules), the optimal time path for incremental consumption should be skewed toward present generations and saving should be directed toward accumulating of domestic private and public capital and cutting debt rather than accumulating foreign assets (van der Ploeg and Venables 2010).
The resulting optimal micro-founded path for incremental consumption shows that effectively, the windfall brings forward the development path of the economy. Although the hypothesis of learning-by doing in the traded sector may be relevant for advanced industrialised economies, developing economies such as Guyana are more likely to suffer from absorption constraints in the nontraded sector especially as it is unlikely that capital in the traded sector can easily be unbolted and shunted to the nontraded sector. This cuts the other way, since it is then optimal to temporarily park some of the windfall in a sovereign wealth fund until the nontraded sector has produced enough home-grown capital (infrastructure, teachers, nurses, etc.) to alleviate absorption bottlenecks and allow a gradual rise in consumption. The economy experiences temporary appreciation of the real exchange rate and other Dutch disease symptoms.
However, these are reversed as home-grown capital is accumulated. There are many other resource management issues.
- First, governments should realise that, if imports are mostly financed by an exogenous stream of foreign exchange coming from resource rents, revenue generated by tariffs is illusory as the increase in tariff revenue is offset by reducing real resource revenue. Tariffs effectively reduce the domestic purchasing power of the windfall of foreign exchange.
- Second, tax capacity typically erodes quickly during windfalls. Since legal and fiscal capacity are likely to be complements (Besley and Persson 2009), this leads to grave concerns about the adequate supply of common-interest public goods such as fighting external wars or inclusive political institutions.
- Third, the political economy windfalls dictate that incumbents may avoid putting resource revenues in a liquid sovereign wealth fund that can be easily raided by political rivals. There is thus, a bias to excessive investment in illiquid, partisan projects, especially if the probability of being kicked out of office is high (Collier et al. 2010). There may also be a tendency to overinvest in partisan projects with negative social sur plus (“white elephants”) if politicians find it hard to credibly commit to socially efficient projects (Robinson and Torvik 2005).
- Fourth, harnessing windfalls in face of the notorious volatility of commodity prices implies that governments build precautionary and liquidity buffers (by postponing spending and bringing taxes forward) and extract natural resources excessively fast to minimize the commodity price risk of future remaining reserves, especially if the degree of prudence is high and commodity price shocks are persistent and have high variance (van der Ploeg 2010).