Oil, institutions and economic performance: a comparative study.

Author:Azarhoushang, Behzad
Position:Report
 
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  1. Introduction

    It is a common belief that oil revenue can help countries to accelerate economic growth and development. However, by looking at the economic situation of the most oil rich countries, slow growth and poor performance are observed. A research study by the UNDP in 2008 showed that during 1975-2005, the average annual per capita GDP growth rate of oil exporters was close to zero (0.03 percent), while this rate for oil poor countries was 3.4 percent on average.

    Oil exporting countries have experienced massive windfall gains since 2005 and despite the fall of oil prices since mid-2008 their oil revenue still is very high compared to 1980s and 1990s. These countries would like to use the revenue of exporting natural resources to finance their development projects and pave the way to a sustainable economic growth. Yet, oil price hikes may hinder the economic development in these countries. In fact, increases in the earnings of oil exports during the last three decades were associated with a decline in growth rates of most oil exporters (Askari, 2006). The Dutch Disease literature emphasizes the effects of economic factors, especially the real exchange rate appreciation, as the major cause of poor economic growth of resource-based economies. The intertwined political and economic factors, a high rate of corruption, rent seeking and weak institutions can create deep and long lasting negative effects of oil revenues in these countries. A focus on existence and effectiveness of institutions as vital role in development is emphasized by resource curse literatures (Karl, 1997; Auty, 2001 and 2004; Humphreys et al., 2007).

    Rich natural recourse countries such as Norway and the Netherlands with a high level of development and sustainable economic growth raised different questions for economists regarding how these countries manage their economy. Is their success due to preventing currency appreciation, or the existence of effective institutions?

    Existing literatures looked at this issue either from Dutch Disease theory by studying the economic performance of oil rich countries or from Resource Curse by examining the quality of institutions in these countries. But this paper tried to capture both perspective with more emphasize on institutional qualities and its effects on economic performance. This paper looks at good governance and macroeconomics indicators of Iran and Turkey (because of their similarity in population and geographical area), Russia and China as big countries to illustrates that countries that have not oil have better institutional quality and hence better economic performance. Norway is also chosen as a successful oil rich country with sustainable development that has been ranked first on the world by Human Development Index (UNDP, 2012) in order to show that an oil rich country with effective institutions can have brisk economic performance.

    This paper consists of six sections. The second section, after the introduction, reviews theories about Dutch Disease and the Resource Curse and studies the related literatures. Section 3 presents Iran's and Turkey's historical background, policies, institutions and compares the economic performance of these countries in the last decade. Section 4 studies Russia's and China's economic and institutional performance. Section 5 investigates Norway's policies and looks at the differences and similarities of institutional arrangements in Norway compared to Iran and Russia. The last section concludes.

  2. Theoretical Debate

    There have been several approaches in the literature to account for the poor economic performance of oil rich countries. Dutch Disease and Resource Curse are the most important theories for explanation of weak economic performance of resource rich countries.

    2.1. Dutch Disease

    The first is associated with the notion of the Dutch Disease. The term "Dutch Disease" was coined in the late 1970s after Economist identified a link between the discovery of large deposits of natural gas in the Netherlands and the decline of the manufacturing sector (Economist, 1977).

    The "Dutch Disease" happens when discovering of rich natural resource such as oil and natural gas led to improving their exports. If the oil and/or natural gas revenue spend direct or indirectly in domestic market, it will increase the aggregate demand which will led to inflation and improving real domestic currency. Strong domestic currency could decrease the competitiveness of tradable sectors (especially manufacturing commodities) of oil exporting countries in international trade. Dutch Disease literature puts emphasize on spending effects and resource movement effects after increase in oil revenue as two main channels which have negative effects on tradable sectors.

    Spending effects: If natural resource revenue spends in non-tradable sectors such as real estate market, the price of these sectors will increase more than tradable goods which lead to improve of real exchange rate of the oil exporting country. The latter will harm the competitiveness of tradable sectors in international markets and decrease their exports.

    Resource movement effects: In line with improving the demand for a nontradable sector, wages in this sector will increase and therefore absorb workers from other sectors. This effect will decline the production and resource for tradable sectors (Corden and Neary, 1982).

    Extraction of natural resources sets in motion a dynamic that gives primacy to two domestic sectors, the natural resource sector and the nontradable sector, such as the construction industry, at the expense of agricultural and industrial investment, production and exports (Bruno and Sachs, 1982; Wijnbergen, 1984a).

    The Netherlands was a developed country that suddenly faced massive job problems in the 1970s because their industries could not compete with international rivals. The country quickly changed its economic policy and regained competitiveness in tradable sectors again. Yet, the problem of Dutch Disease has for decades plagued resource rich developing countries.

    The combination of demand push inflation and appreciation of the real exchange rates results in an often dramatic decline in the competitiveness of non-oil exports and erosion of diversity and balance in the domestic economy (Wijnbergen, 1984b).

    The Dutch Disease symptoms which accompanied the oil windfall lead to overvaluation of the domestic currency and increases in nominal wages, creates a movement of resources, including labor, from the tradable (agriculture and manufacturing) sectors into the non-tradable (construction and services) sectors. Increasing production costs, while the real exchange rate is appreciated, weaken the competitiveness in the international markets. A decline in traditional exports and inflows of cheaper imported goods destroy a high proportion of job opportunities (Corden, 1984).

    2.2. Resource Curse

    Evidence of Dutch disease has been identified in almost all countries where petroleum exports play a major economic role (Corden, 1982; Corden and Neary, 1982). However, it can't explain why there is no tendency towards changing policies, even when these policies led to a drastic decline in production and employment. These surprisingly unsuccessful outcomes cannot be fully understood separate from institutional development. Many empirical studies have approved this idea that combined economic and political factors cause natural resource wealth to become a curse (Karl, 1997; Auty, 2001 and 2004; Humphreys et al., 2007).

    In 1993 Richard Auty created the term "Resource Curse" and argued that Dutch Disease is not the only reason for poor performance of oil rich countries. Weak institutions, corruption, rent seeking, and wrong policy-making of government have more negative effects than Dutch Disease in these countries (Bulte and Wick, 2006). Dependence on oil shapes social classes, regime types, institutions, the framework for decision-making, and the decision calculus of policymakers (Karl, 1997). The experiences of the past four decades show that oil wealth negatively affects the quality of institutions, and institutional quality is in turn an important determinant of economic growth. Various oil exporters such as Venezuela, Iran, Nigeria, Algeria and Indonesia demonstrate striking similarities in macroeconomic performance. Auty (2001) argues that resource-rich countries, especially oil exporters, tend to be dominated by factional and predatory oligarchic polities and suffer from policies that postpone the transition to competitive industrialization and diversification of the economy. Political fragmentation, recurring conflicts, and authoritarian rule hamper the development of democratic institutions and remain major obstacles to economic reform.

    Ross (2001) states that growth failures are the outcome of strong associations between resource wealth and the likelihood of weak democratic development. In most oil exporting countries political parties are often weak and formed around charismatic leaders while military intervention in politics are common and political support derives from systems of patronage. The short-horizon politics of competition for power and state-allocated resources gives rise to unstable policy regimes and non-transparent mechanisms of rent distribution, encouraging the development of clientelistic networks and rent-seeking behavior throughout state and society. Elections can be rigged using the oil revenues when governments are not accountable to the public. Nondemocratic governments sometimes can also count on acceptance and support from the governments of oil-consuming countries to prevent any democratic transfer of power. Politicians with an uncertain hold on power have an incentive to spend sooner than later to leave no opportunity on the table for future political opponents. Huge oil revenues allow governments to mollify dissent and avoid accountability, insulating governments...

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