Economics 101: Volatility is among perils of riding a resource boom

Natural resource booms are sometimes referred to as a “poisoned chalice” for economies that experience them.

A quick glance at Africa, Latin America and the Middle East suggests that oil, diamonds and other valuable deposits can bring about more misery than prosperity. There are many potential reasons for the paradoxically harmful effect of natural resources on the economy: one of them is volatility, and unlike the Dutch disease explanation considered last week, it potentially applies to the GCC.

In a globalised economy, the benefits of a natural resource boom are amplified by countries exporting most of these resources in exchange for imports of consumption and investment goods. For example, Qatar sells its natural gas to countries such as Japan, and uses the proceeds to buy the Toyota Landcruisers that are such a common sight in Doha, as well as the materials and foreign expertise necessary to build the stadiums for the 2022 Fifa World Cup.

A problem arises if natural resource exports are the dominant source of income in the economy, because global commodity prices are quite volatile, meaning that the volatility is transmitted to the economy.

For example, at the start of 2017, oil was at about US$55 a barrel; in January last year, it was around $30 a barrel; two years ago, in January 2014, it was $110 a barrel. In the early 2000s, it was below $20 a barrel.

For an oil exporter such as the UK, these gyrations are of limited consequence because oil profits accounted for 0.2 per cent of GDP in 2015, but in Kuwait, the corresponding figure was 39 per cent.

Why is volatility undesirable? Because the primary source of economic growth is investment, especially long-sighted projects such as infrastructure and R&D, and investment planning becomes very difficult when the economy is fundamentally unstable. Can you imagine how challenging it would be to take on a mortgage if your income could double or half from year to year? Inevitable, you would have to settle for a much smaller house than the one that you would seek with a stable income.

This problem is especially acute in the exports sector, which is a key source of jobs in advanced economies. Global markets are intensely competitive, and small changes in costs and prices can have profound consequences for the market share of an exporter. Natural resource volatility affects the availability of capital for prospective exporters, as well as inducing significant undulations in the exchange rate, further impairing investors’ ability to put together a coherent, implementable plan. Substantial volatility, therefore, typically results in low investment, and an emphasis on short-term projects at the expense of the ones that bear fruit over decades.

Can resource-dependent countries dampen the volatility? A favoured countermeasure is to invest resource proceeds heavily in foreign assets that deliver returns that are far more stable than the prices of global commodities. This is why the GCC countries have established huge sovereign wealth funds, buying billions of dollars of foreign bonds, shares and property. Norway, owner of the biggest fund, places strict restrictions on how much of the resulting income and accumulated capital can be used year-to-year.

Ultimately, there are limits to the amount of hedging that can be done, because commodity prices are “non-stationary”, meaning that they do not fluctuate around a stable mean; instead, they tend to meander in a completely unpredictable fashion, and so policymakers can never tell if current prices are actually high or low looking forward.

Moreover, citizens exhibit their human nature by placing political pressure upon governments to consume the fruits of a resource boom in the present, rather than saving it for future generations, further limiting policymakers’ efforts at stabilising the economy.

Therefore, a critical step towards ensuring the beneficence of natural resources is diversifying the economy, which is why there are no mentions of the resource curse in generously endowed countries such as Australia and the US.

Omar Al Ubaydli is the programme director for international and geopolitical studies at the Bahrain Centre for Strategic, International and Energy Studies, and an affiliated associate professor of economics at George Mason University in the US. He welcomes economics questions from readers via email (omar@omar.ec) or tweet (@omareconomics).

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