Don’t Blame the Abundance of Oil! The Volatility in Oil Revenues Combined With Poor Governmental Responses to these Volatilities Drives the Resource Curse

This blog is written by Kamiar Mohaddes, Senior Lecturer and Fellow in Economics at Girton College, University of Cambridge, UK.

According to the resource curse paradox, abundance of oil (natural gas, minerals and other non-renewable resources) is believed to be an important determinant of economic failure. But is the poor performance of resource-rich countries, when compared to countries which are not endowed with oil, due to the abundance of oil in itself or is the curse instead due to price volatility in global oil markets and production volatility due to political factors (such as wars and sanctions)? More importantly, is there a role for institutions and the government (in particular fiscal policy) in offsetting some of the negative growth effects due to the curse?

What do we know about the curse?
Although the early literature showed the existence of a negative relationship between real GDP per capita growth and resource/oil abundance, more recent evidence is not so clear cut. Firstly, the early literature used cross-country analysis that fails to take account of dynamic heterogeneity and error cross-sectional dependence, and this could bias the results. Secondly, the early analysis ignores the effects of oil revenue volatility on growth, which turns out to be important.

Figure 1 shows that for major oil producers, there is a positive relationship between the volatility in oil revenue and GDP growth (measured by its standard deviation over the full sample), but a clear negative relationship between real GDP per capita growth and its volatility. This suggests that the excess volatility in oil prices and production is associated with higher volatility in GDP growth, which in turn has a negative effect on output growth. We shall see now whether these results continue to hold when we use more advanced econometric techniques.

Figure 1: Scatter Plots of GDP Growth and Volatility of Oil Revenue Growth against Volatility of GDP Growth, 1961-2013

 

first grpah second grpah
Source: Author’s calculation based on data from World Bank World Development Indicators, Penn World Table Version 8.0, and International Monetary Fund International Financial Statistics databases. These are cross-sectional averages over 1961-2013.

 

What are the main results?
Using annual data on a sample of 17 major oil producers over the period 1961-2013 and appropriate econometric techniques that take into account all three key features of the panel (dynamics, heterogeneity and cross-sectional dependence), we study the long-run effects of oil revenue and its volatility (an annual country-specific measure of revenue volatility) on economic growth under varying institutional quality.

Our results suggest that:

  • there is a significant negative effect of oil revenue volatility on output growth;
  • higher growth rate of oil revenue significantly raises economic growth; and
  • better fiscal policy can offset some of the negative effects of oil revenue volatility.

Therefore, while abundance of oil in itself is growth-enhancing, the main problem in terms of long-run growth is the adverse effects of excess oil revenue volatility due to, for instance, large swings in government expenditure. Because revenues are highly volatile, their management needs appropriate institutions and political arrangements so that the domestic expenditures from oil revenues become less volatile.

Seen from this perspective, oil revenue can be both a blessing and a curse, and the overall outcome very much depends on the way the negative effects of oil revenue volatility are countered by use of suitable policy mechanisms that smooth out the flow of government expenses over time.

So, what are the key policy recommendations?
The undesirable consequences of oil revenue volatility can be avoided if resource-rich countries are able to improve the management of volatility in resource income by setting up forward-looking institutions such as Sovereign Wealth Funds (if they have substantial revenues from their exports), or adopting short-term mechanisms such as stabilization funds with the aim of saving when commodity prices are high and spending accumulated revenues when prices are low.

The government can also intervene in the economy by increasing public capital expenditure when private investment is low, using proceeds from the stabilization fund. Alternatively the government can use these funds to increase the complementarities of physical and human capital, such as improving the judicial system, property rights, and human capital. This would increase the returns on investment with positive effects on capital accumulation, TFP, and growth. Improving the functioning of financial markets is also a crucial step as this allows firms and households to insure against shocks, decreasing uncertainty and therefore mitigating the negative effects of volatility on investment and economic growth.

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