The role of the invisible hand and diversion in Guyana’s natural resources development

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Bobby Gossai, Jr.
Bobby Gossai, Jr. is currently pursuing the Degree of Doctor of Philosophy in Economics at the University of Aberdeen with a research focus on Fiscal Policies and Regulations for an Emerging Petroleum Producing Country. He completed his MSc (Econ) in Petroleum, Energy Economics and Finance from the same institution, and also holds an MSC in Economics from the University of the West Indies. Mr. Gossai, Jr.’s professional experiences include being the head of the Guyana Oil and Gas Association and senior policy analyst and advisor at the Ministry of Natural Resources and Environment.

The fact that privatisation did not solve the problem of resource diversion should not have come as a surprise: profit-maximizing private enterprises naturally seek to minimize what they give to the government for their rights to control the use of the asset.

Modern capitalism is, by and large, based on a simple calculus: each individual is concerned with how much he/she can get for themselves. Under highly restrictive (never satisfied) conditions, Adam Smith was right that the pursuit of self-interest leads, as if by an invisible hand, to economic efficiency; but more generally, it may not. Adam Smith and his followers assumed perfect information; or at least that there were no agency problems (Greenwald and Stiglitz 1986; Arnott et al. 1994).

In many cases, the pursuit of self-interest (greed, by any other name) by multinational corporations, investment banks, and accounting firms have not led to efficient investment, though some individuals have themselves been amply rewarded. And so far, at least, few have wound up paying any criminal penalties (Stiglitz 2003).

It is a standard doctrine, at least among economists and in much of the business community, that firms should maximize the stock market value. Almost every business school teaches that this is what managers are supposed to do. If they do not, they will be punished, either by being dismissed by their shareholders or by being taken over. These doctrines have strong implications: If a firm can get control of oil at one-tenth of the market price by paying a ten million dollar bribe to a government official, a firm maximizing shareholder value should do so, so long as the expected penalties are not too great. If a mining company can somehow get out of a country without having to pay the full costs of clean-up, it should do so; if it is necessary to bribe some government official, or to make a campaign contribution, that is just a necessary business expense.

While some firms would shy away from the crassness of the behaviour just described, the market economy rewards it. If a country auctions off its natural resources, the firm willing to pay the highest price is not necessarily the firm which is most efficient in extracting the resources. Rather, it might be the one most efficient in having the government pick up the clean-up costs, for example, minimizing the bribes required. And few firms would shy away from active involvement in politics, in making campaign contributions (“investments” from which they expect, and typically do get, returns).

Privatisation and the Scope for Diversion

Privatisation actually increases the scope (opportunities and incentives) for corruption, by increasing the potential for connivance between government officials and others for diverting resources away from the public good. The returns to corruption are higher and there is now a much wider range of hard-to-detect mechanisms for diversion. Prior to privatisation, government officials can only divert a fraction of the flow of revenues; with privatisation, government officials today can divert a fraction of the total value of the resource – the present discounted value of the future flow of revenues. The greater pay-off for corruption provides greater incentives for corruption – and the record shows that individuals do respond to incentives. Privatisation often affords enormous opportunities for apparently legal (though typically non-transparent) ways of driving down the price paid for the resource.

The problems detailed below are, for the most part, jointly problems of the private and public sector – the agency problems in the two reinforce each other. The private sector exploits the public sector agency problem, the fact that the interests of the government official do not coincide completely with those he or she is supposed to serve. Even if the corporation, as a matter of official policy, does not seek to exploit the public sector, standard compensation schemes in the private sector provide incentives for their “agents” to do so.

Efficiency

While the discussion centres on the problem of maximizing the revenue accruing to the government, and focuses in particular on the problem of diversion, it should be clear that this is not a zero-sum game. It is not just a matter of diversion. In the process, resources often are not used well; resources may be extracted too quickly, without due attention to environmental consequences. Taking the wealth generated out of the country to protect it from recapture may have large macro-economic consequences.

By most accounts, Norway’s state oil company was both efficient and incorruptible; probably few countries have been able to realize for its citizens a larger fraction of the potential value of a country’s resources. In the case of Norway, institutional change may make little difference in either direction; elsewhere however such opportunities for resource diversion may be quickly seized upon.

Norway’s story is important because it destroys the shibboleth that efficiency and welfare maximization can only be obtained through privatization. Nor is Norway alone. Malaysia also claims to be the global champion and argues that its state-run oil company is able to garner for Malaysia a larger fraction of the value of that country’s oil resources than it could have otherwise achieved. The very process of privatisation introduces a major opportunity for resource diversion, and those arguing for privatisation must show that the losses from maintaining the resources within the public sector are greater than the combined losses associated with the transfer and the losses from agency problems after privatisation (Stiglitz 2006).

Agency problems are not the only reasons that privatisations sometimes fail – or at least fail to perform as expected. There are also problems with commitment. On the one hand, once the investments have been made, governments may attempt to renegotiate for better terms, threatening to take over the assets.

To protect themselves, investors may extract resources more rapidly than is optimal. On the other hand, at some point, the oil or mining company may threaten to shut down operations unless better terms are negotiated.

The problem for the government is that it may not know whether such threats are credible because it does not know the true operating costs of the firm. For instance, if the costs really are too high, then it pays for the government to renegotiate in order to improve the incentives of the company. If it does not pay, however, the government could find some other firm to operate the well under the original terms. This last option, however, might not be feasible if other oil companies also do not know the extraction costs.

Then, assuming there are fixed costs to entering into the contract, they might infer that costs are prohibitive from the very fact that the other company left. Making matters worse, in simple bargaining problems with imperfect information, it may even pay the oil company to shut down operations (effectively go on strike) to improve the terms of its contract, even when production would be profitable for the company.

Therefore, such asymmetries of information mean that, even when ex-ante markets were highly competitive, ex-post, the existing operator has some market power. It is often hard to design renegotiation-proof contracts. Requiring companies to post large bonds may make it less likely for firms to engage in such behaviour. Nonetheless, there may be a large cost to such a requirement because of what is sometimes called the double moral hazard problem; the oil or mining company may worry that, even if it behaves impeccably, some future government may impose conditions that make operations so unattractive that it will want to withdraw, thereby “unfairly” forfeiting the bond. 

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