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Managing Resource Revenues in Developing Economies
PAUL COLLIER, RICK VAN DER PLOEG, MICHAEL SPENCE,
and ANTHONY J. VENABLES
This paper addresses the efficient management of natural resource revenues in
capital-scarce developing economies. It departs from usual prescriptions based on
the permanent income hypothesis and argues that capital-scarce countries should
prioritize domestic investment. Because revenue streams are highly volatile,
governments should protect consumption from shocks by increasing it only
cautiously. Volatility in domestic investment can be moderated by a buffer of
international liquidity, but it is also important to structure investment processes
to be able to cope efficiently with substantial fluctuations. To date, most of the
resource-rich countries of Africa have not had investment rates commensurate
with their rate of resource extraction.[JEL D60, E21, E62, F34, H00, Q33]
IMF Staff Papers (2010) 57, 84–118. doi:10.1057/imfsp.2009.16;
published online 21 July 2009
The revenues from exhaustible natural resources are distinctive in two key
respects: because they are derived from depleting a finite stock of
resources they are intrinsically temporary, and because commodity prices
are highly volatile they are unreliable. It is generally recognized that
Paul Collier, Rick van der Ploeg, and Anthony J. Venables are professors of economics
at the University of Oxford. Michael Spence is a professor of economics at Stanford
University and a Nobel Laureate in Economics. This paper was supported by the BP funded
Oxford Centre for the Analysis of Resource Rich Economies and by the Centre for the Study
of African Economies. The authors thank Rolando Ossowski for sharing his data on fiscal
policies and hydrocarbon revenues with us, and thank Nicolas van de Sijpe for his able
research assistance.
IMF Staff Papers
Vol. 57, No. 1
&2010 International Monetary Fund
84
unsustainable increases in consumption are undesirable: consumption habits
may form and commitments may be made, so that declines in consumption
are very costly, economically and politically. This indicates the importance of
saving some proportion of the revenues from a resource boom, so that
increases in consumption can be sustained after the boom. At the same time
many of the countries in the developing world with natural resources are
not yet on sustained high growth paths. There are a variety of reasons
for this, an important one of which is a pattern of underinvestment in
the tangible and intangible assets that are public goods, prominently in
education, infrastructure, and capacities associated with effective government
and economic management. Resource revenues—even if temporary and
unreliable—provide a way to finance such investments. This paper addresses
the question of how best to manage resource revenues to achieve increases in
consumption which do not need to be reversed. There are two critical sets of
choices that need to be made. One is how much and in what to invest in order
to secure a desired consumption profile. The other is how to manage this
in the face of revenue volatility. A developing country may or may not be on
a sustainable high growth path when it discovers natural resource wealth or
an increment to it. The vast majority are not. If not, then natural resource
wealth is an opportunity to make investments that move it toward such
a path. If a country is on such a path then the discovery of natural resource
wealth can be used to elevate both growth and consumption in the short to
medium run. Revenues are likely to be volatile and there is a need to cushion
the impact of this volatility, but not at the expense of preventing the domestic
economy from benefiting from commodity booms.
Consider the issue of sustainability from the perspective of depletion.
Because the revenues derived from sales of exhaustible resources are
transient, for an increase in consumption to be sustainable at least some of
the revenue must be used for asset acquisition. Potentially, there are two key
issues raised by an asset strategy: How much of the revenue should be used
for asset acquisition? And what assets should be acquired?
To date, most policy attention has been focused on the former of these
issues—how much to save? This may be because one simple answer can
be derived very easily from elementary economic analysis based on the
permanent income hypothesis (PIH). This is the analytic foundation for the
policy rule of sovereign wealth funds (SWF). We argue that this policy rule
is seriously inappropriate for a developing country. Our key point is
that the issue of how much to save cannot be addressed until the prior,
and more important, issue of what assets should be acquired has been
considered. Developing countries are normally capital scarce, so that assets
should be accumulated by investment within the country rather than in
foreign financial assets which will, on average, yield a lower return. In effect,
the SWF needs to be built up initially within the country. Direct public
investment in assets with a high social return, or the acquisition of high-
yielding domestic assets instead of low-yielding global assets, has two
powerful implications.
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
85
One is that the high yield will in aggregate imply that resource-rich
developing countries can expect (or at least hope for) rapid growth. As a
consequence, the value to the society of consumption in the near term is
considerably higher than consumption in the distant future when the
economy has become fully developed. Note this is not because we presume a
high rate of time preference, but rather that people are much poorer now that
they will be in the future so the marginal social value of an incremental dollar
of consumption now is high even if the rate of time preference is very low or
zero. It is therefore appropriate for a developing country to use some of its
resource revenues to raise consumption up toward the level of the distant
future, rather than to use them to raise the level of consumption in that
distant future. This strategy contrasts with the PIH, which provides a
solution for a society wishing permanently to raise its consumption and
thereby placing relatively high weight on the interests of the distant future.
The other implication of using revenues for domestic asset accumulation
is that the return on assets becomes dependent upon the domestic investment
process. Although the economy is capital scarce, the investment process may
not be able to deliver high returns. One issue is that, beyond a point, the sheer
volume or rate of increase of investment may encounter both managerial and
physical bottlenecks that depress marginal returns, especially in the
construction and other nontraded sectors of the economy. To counter this
it is important that countries invest first in their capacity to make effective
investments and manage projects, particularly because some of the key
capital assets (especially infrastructure and human capital) cannot be
imported from abroad.
Another issue is the role of actions to stimulate private investment. High
growth countries invest 5 to 7 percent of GDP per year (over and above
expenditures on basic education) in incremental education and infrastructure
whereas, in contrast, most countries with lower growth invest only around 3
percent (Commission on Growth Development, 2008). This deficit leads to a
situation in which private investment is discouraged and the economy is
uncompetitive with respect to global alternatives. Resource revenues may
provide a way to break out of this trap of low public and private investment.
Commodity prices are highly volatile and hence so are revenues. Unless
fluctuations can be hedged through financial instruments, they must give rise
to variation in some combination of three things: consumption, the foreign
asset/ debt position of the country, or domestic investment. We have already
suggested that fluctuations in consumption are undesirable, so what about
the other options?
One ‘‘grand’’ strategy would be to build up a sovereign liquidity fund
(SLF) to smooth expenditures. An SLF would differ from an SWF in its
intended purpose and hence have both a different scale and a different
composition of assets which would need to be much shorter-term. Supposing
that the government knew with certainty the net present value (NPV) of the
resource rents, it could choose the maximum path of expenditure on
investment consistent with maintaining high returns, and from this compute
Paul Collier, Rick van der Ploeg, Michael Spence, and Anthony J. Venables
86
the appropriate increase in consumption. In effect, that is the problem that
we solve in Section II. The function of an SLF would simply be to enable
expenditure to stay on this path while actual revenues fluctuated around it.
As we discuss, given the historical path of commodity prices, an SLF would
have needed to be very large in order to achieve this smoothing function.
There is too much uncertainty, both as to the future path of prices, and as
to future resource discoveries, for this approach to be feasible: the NPV of
resource rents is largely unknowable.
One policy designed to cope with this radical uncertainty in the NPV of
revenues is the bird-in-hand rule. This rule tries to address the unpredicta-
bility of revenues by proposing that all revenue should go into the SWF, net
of domestic public sector investment, so that consumption would only rise
due to the rising interest earned as the fund accumulates. This variant of the
PIH rule (without the public sector investment netting out) has been
advocated by the IMF. We have already suggested that an international SWF
is not appropriate for a capital-scarce country. Further, we argue that the
rule is too conservative in that it precludes any near-term increases in
consumption.
The alternative is that domestic investment adjusts, so that during boom
periods resource revenues are translated into domestic capital. Investment is
the most volatile component of income in all countries, suggesting that the
cost of some fluctuation is quite modest. Ramping up large increases in
investment is likely to be wasteful, but countries can adopt systems that
minimize these costs. The issues surrounding these options are discussed in
Section IV.
First, the next section briefly sets out the historical record of the impact
of resource revenues, focussing on their impact on saving and domestic
investment.
I. The Historical Record
The historical record of managing resource revenues has been extensively
researched and extensively reviewed (for example, Ploeg, 2008), and the
consensus is that while resource revenues have a positive effect on economic
growth in countries with good governance, their effect in countries with poor
governance has, on average, been negative. Cross-country evidence suggests
that countries can escape the resource curse (Sachs and Warner, 1997) and
turn the windfall revenue into a boon if they have good institutions (Mehlum,
Moene, and Torvik, 2006), are open to international trade (Arezki and
van der Ploeg, 2008), or have well-developed financial systems (Ploeg and
Poelhekke, 2009).
1
It is notoriously difficult to interpret the macroeconomic
1
Democracy and resource rents also appear to interact badly (Collier and Hoeffler, 2009).
Democracies with no natural resource rents tend to grow more rapidly than autocracies,
resource-rich democracies grow more slowly than autocracies. The degree of electoral
competition determines the process by which a government acquires power, whereas the
number of checks and balances determine the limits on how it can use power. Electoral
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
87
effects of commodity booms in cross-country studies, so it is useful to
examine the dynamics more explicitly. Collier and Goderis (2007, 2008) use
global data from 1960 onward and find that, for the first few years following
an increase in the price of commodity exports, nonresource output does
indeed increase relative to what it would otherwise have been: people become
more productive. However, within two decades the typical resource-extracting
economy is producing less than it would have done in the absence of the boom.
Simulating the recent boom for the typical African commodity exporter, if
global history repeats itself, then after two decades output will be around 25
percent lower than it would have been without the boom.
The key finding in both the cross-section and time-series empirical
literature on commodity booms is thus that the resource curse is not cast in
stone. Some societies have succeeded in harnessing commodity booms for
sustained increases in production, but others have not, with the quality of
governance playing an important role. Resource-exporting countries with
good governance grow more rapidly in the long run as well as in the short
run, Botswana being an African example. Unfortunately, during the period
1963–2003, the critical level of governance required to avoid the resource
curse was above that prevalent in many other resource-rich African societies.
Sustainability of consumption depends on the economy’s asset stock, and
one strand of empirical work on savings has looked at ‘‘genuine savings,’’
taking into account the depletion of natural assets. The formal definition
of genuine saving is public and private saving at home and abroad, net
of depreciation, plus current spending of education to capture changes in
intangible human capital minus depletion of natural exhaustible and
renewable resources minus damage of stock pollutants (CO
2
and parti-
culate matter). The relationship between resource revenues and genuine
saving shown in Figure 1 is at least superficially disturbing. Countries with a
large percentage of mineral and energy rents of GNI typically have heavily
negative genuine saving rates. A number of conceptual issues surround the
use of this measure, including the fact that these different forms of
investment might have different rates of return, so the composition as well
as level of savings matter. If, for example, the domestic rate of return is
double the world interest rate (at which, by the Hotelling, 1931, rule, the rent
on the resource is expected to increase), the depletion of $1 million of natural
assets would be fully offset by $500,000 of domestic investment. Despite the
above qualification, the green accounting figures suggest that unless rates of
return on domestic investment are very much higher than the world interest
rate, investment in resource-rich countries has been far too low. In fact,
public sector investment rates are too low in many developing countries with
or without natural resource rents.
competition damages the democratic process, whereas checks and balances are beneficial. The
evidence suggests that resource rents gradually weaken checks and balances. The governance
challenge for resource-rich Africa may thus be to strengthen checks and balances in the face of
pressures to weaken them.
Paul Collier, Rick van der Ploeg, Michael Spence, and Anthony J. Venables
88
The actual paths of domestic investment and savings in selected oil rich
countries are shown in Figure 2. The last two panels of this figure show
Norway and Saudi Arabia where savings generally exceed and move in line
with hydrocarbon revenues. Gross domestic investment appears unrelated to
these revenues, indicating the acquisition of overseas assets. Other panels give
African countries and indicate a similar pattern of co-movement of savings
and hydrocarbon revenues for Algeria, Angola, Libya, Nigeria, and Sudan, at
least since the late 1990s; for Angola, Libya, and Nigeria the level of saving is
however less than revenues. There is little evident relationship between
resource revenue and domestic investment, this observation confirmed by
simple statistical tests. In all these countries hydrocarbon revenues rose
sharply. However, in none of them was there a substantial increase in the share
of domestic investment. Only in Equatorial Guinea was domestic investment
as a share of GDP at a level that might look appropriate when benchmarked
against China. However, in this tiny economy investment is dominated by that
of the oil companies building extractive capacity and so does not indicate a
major push by the government to build capacity in other sectors.
II. Harnessing Windfall Revenue: The Case of Certainty
We now turn to the decisions facing policymakers, looking first at the case
where the future flow of natural resource revenues is known with a high
Figure 1. Genuine Saving and Exhaustible Resource Share
Source: World Bank (2006, Figures 3 and 4).
Note: 1970–2003 average, at least 10 oberservations per country.
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
89
degree of certainty. Even abstracting from uncertainty, they nevertheless face
a challenging set of decisions. How should the country plan the time path of
spending and saving from the revenue flow, and what assets should be
acquired for increases in consumption to be sustainable? Directing all
resource revenue to current consumption is both wasteful and inequitable,
but so too is postponing the consumption benefits into the far distant future.
Figure 2. Responses to Hydrocarbon Revenues in Some Sub-Saharan Countries
15
20
25
30
35
40
45
50
55
19921993 199419951996 199719981999 200020012002 200320042005
Gross national savings, % GDP
Gross domestic investment, % GDP
Hydrocarbon revenue, % GDP
Algeria
0
5
10
15
20
25
30
35
40
45
19921993 199419951996 199719981999 200020012002 20032004 2005
Gross national savings, % GDP
Gross domestic investment, % GDP
Hydrocarbon revenue, % GDP
Angola
2
4
6
8
10
12
14
16
18
20
19921993 19941995 1996 19971998 19992000 2001 20022003 20042005
Gross national savings, % GDP
Gross domestic investment, % GDP
Hydrocarbon revenue, % GDP
Cameroon
-40
-30
-20
-10
0
10
20
30
40
50
60
19921993 19941995 1996 19971998 19992000 2001 20022003 20042005
Gross national savings, % GDP
Gross domestic investment, % GDP
Hydrocarbon revenue, % GDP
Chad
0
10
20
30
40
50
60
19921993 19941995 1996 19971998 19992000 2001 20022003 20042005
Gross national savings, % GDP
Gross domestic investment, % GDP
Hydrocarbon revenue, % GDP
Congo, Rep.
-20
0
20
40
60
80
100
120
19921993 19941995 1996 19971998 19992000 2001 20022003 20042005
Gross national savings, % GDP
Gross domestic investment, % GDP
Hydrocarbon revenue, % GDP
Equatorial Guinea
Paul Collier, Rick van der Ploeg, Michael Spence, and Anthony J. Venables
90
The optimal intertemporal profile of consumption depends on views about
the value of consumption accruing at different times and to different
generations, and about the rate of return that can be obtained by postponing
consumption and investing in assets of different types. We explore
the interaction between the consumption and investment sides of the
equation.
10
15
20
25
30
35
40
45
19921993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Gross national savings, % GDP
Gross domestic investment, % GDP
Hydrocarbon revenue, % GDP
Gabon
10
20
30
40
50
60
70
19921993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Gross national savings, % GDP
Gross domestic investment, % GDP
Hydrocarbon revenue, % GDP
Libya
10
15
20
25
30
35
40
19921993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Gross national savings, % GDP
Gross domestic investment, % GDP
Hydrocarbon revenue, % GDP
Nigeria
0
5
10
15
20
25
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Gross national savings, % GDP
Gross domestic investment, % GDP
Hydrocarbon revenue, % GDP
Sudan
5
10
15
20
25
30
35
40
19921993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Gross national savings, % GDP
Gross domestic investment, % GDP
Hydrocarbon revenue, % GDP
Norway
10
15
20
25
30
35
40
45
19921993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Gross national savings, % GDP
Gross domestic investment, % GDP
Hydrocarbon revenue, % GDP
Saudi Arabia
Figure 2. (Continued)
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
91
Investment and Consumption in a Capital-Scarce,
Resource-Rich Economy
On the consumption side, the social discount rate (SDR) measures the value
of consumption one period in the future relative to consumption today,
future consumption being discounted by factor 1/(1 þSDR). Although future
consumption is worth less than consumption today, this is offset by the fact
that investment yields a positive return, and we denote by r
F
and r
D
the rate
of return on foreign and domestic investments respectively. The choice of
what to do with revenue today is informed by comparison of these rates.
Efficiency requires that revenue should be consumed today if SDR is greater
than r
F
and r
D
, and otherwise invested in the highest return activity. The
levels of consumption and investment undertaken will change these rates of
return, so an efficient outcome will see them all equalized.
The classic utilitarian way to formulate a measure of aggregate social
well-being through time is the present value of the utility of consumption, and
this provides a basis for thinking about the SDR. According to this
formulation the value of consumption at one date relative to another depends
on two things, the rate of pure social time preference and the difference in per
capita income (and hence the marginal utility of income) between dates.
Many authors have argued that the rate of pure time preference (r) should be
very low, because there is no ethical reason to attach less importance to
future generations than the present.
2
Although this suggests a low SDR,
the second element captures the fact that we expect future generations to be
richer than us. Equity then suggests that revenues should be used to increase
consumption of the current, relatively poor, generation. This factors into the
SDR by combining the expected rate of growth of consumption, .
C/C,
with society’s attitude toward inequality as summarized by parameter s
(the elasticity of the marginal utility of consumption) which measures the
value of marginal consumption to poor people relative to richer. Combining
these terms, the SDR is SDR ¼rþ.
C/sC. The parameter sis often taken to
be around unity (or perhaps somewhat less), so this SDR might range from
around 10 percent in a fast growing economy to 2 to 3 percent in a mature or
slow growing country.
Turning to investment alternatives, the first distinction is between foreign
and domestic investment. The rate of return on foreign investment, r
F
,
depends on whether a country is borrowing or lending on world markets. For
a lending country—for example, a country accumulating foreign exchange
reserves or building up an SWF—this rate can be regarded as exogenous and
equal to the world interest rate, r
. But for a country that has existing foreign
2
According to this view, the only reason for it to be positive at all is the probability of
human extinction and that future generations will not exist. These arguments have been
re-evaluated in the context of climate change (Stern, 2006). An additional argument for using a
low discount rate is that there is a probability that future generations may be much poorer
than us (Weitzman, 2007).
Paul Collier, Rick van der Ploeg, Michael Spence, and Anthony J. Venables
92
debt and which is considering using resource revenue to pay down this debt
the value of r
F
is likely to be higher, and increasing in the level of debt.
Evidence on interest rate spreads (for example, Akitoby and Stfratmann,
2008) suggests that indebtedness raises the interest paid by countries, so the
marginal value of paying down foreign debt may be large.
Most important, and most difficult to assess, is the return on domestic
investment, r
D
. Our starting point for thinking about this is that developing
countries are capital scarce and likely to have a record of low saving and
underinvestment in both public and private assets. Lack of investment
suggests that r
D
should be high, but the argument is qualified by two points.
One is that private returns may be reduced by lack of investment opportunity
and lack of complementary public inputs. The other is that poor selection
and implementation of investment projects might result in low returns; we
return to this issue in Section IV.
Figure 3. What to Do with Windfall Revenue under Alternative Rules
Profiles of incremental consumption
Profiles of incremental asset holdings
$
Optimal
PIH
PIH
Revenue flow
Bird-in-hand
Optimal
Bird-in-hand
No saving
Years
Years
$
01020304050
01020
30 40 50
a
b
Note: PIH ¼permanent income hypothesis.
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
93
To study alternative paths of consumption and saving out of resource
revenues we structure discussion around the example illustrated in
Figures 3 (a) and (b), showing time profiles of incremental consumption
and incremental national asset accumulation under different rules for con-
suming/saving a temporary anticipated windfall of revenue. For simplicity,
the revenue flow is assumed to be a step function, as illustrated by the
revenue-flow line in Figure 3(a); we assume revenue flows for a 20-year
period, anticipated to start in 10 years time and end in 30 years time.
If society consumed the revenue as it came in—with no asset accumu-
lation nor borrowing in advance of revenue flows—then the same curve
would give the time profile of consumption. This would be a highly sub-
optimal policy to follow, and we now discuss the alternative cases illustrated
in the figures.
Benchmark: Prescriptions Based on the PIH
The benchmark case is where the resource revenue is used to give all generations
an equal increase in consumption. This has a superficial attraction of appearing
equitable, and has a rationale from the well-known PIH, under which a
windfall is perceived as an increment to wealth, and consumption from the
wealth is smoothed through time. This hypothesis is familiar from the tax
smoothing literature (Barro, 1979) or the optimal use of the current account
(for example, Sachs, 1981), and underlies much of the advice for the setting up
of an SWF proffered by the IMF (for example, Davis and others, 2002; Barnett
and Ossowski, 2003; Ossowski and others, 2008).
The dashed line PIH illustrates this strategy for our hypothetical resource
revenue flow. The increment to consumption is constant, and equal to the
interest that would be earned at a fixed world interest rate on the present
value of the revenue, evaluated at discovery date t¼0. Notice that this
strategy involves smoothing consumption from the date at which the resource
windfall is ‘‘discovered.’’ It therefore involves borrowing during the period
in which permanent income exceeds actual income, but saving and
accumulating assets when actual income exceeds permanent income. Thus,
in Figure 3(b) the country borrows (has negative incremental assets) for the
first 10 years, then starts to pay back this debt when resource revenues come
in, then building up a savings fund. The size of the savings fund and level of
consumption increment at all dates are such that interest payments on
the fund (once resource revenue has come to an end) exactly finance the
consumption increment. Because the level of consumption is determined in
this way, the shares of revenue that are saved/consumed at any date fluctuate
with the magnitude of current revenue flow.
3
3
Notice that the permanent income hypothesis holds true economic wealth (that is,
resource wealth under the ground plus financial assets) constant at all dates from discovery
onwards. Thus, borrowing in the early years equals the increase in the present value of
resource revenue which is occurring as the windfall revenue becomes less far distant.
Paul Collier, Rick van der Ploeg, Michael Spence, and Anthony J. Venables
94
This benchmark case is optimal only under special circumstances. It is
applicable for an economy able to borrow and lend at the world rate of
interest and which has thereby aligned the rates of return on different
activities, so rþ.
C/sC¼r
D
¼r
F
¼r
. The response to the windfall is
therefore not to seek to push consumption forwards or backwards in time
(changing .
C/C), but simply to have a one-off increase in its level.
4
Further-
more, the incremental assets should be held in foreign assets, because
additional investment in the domestic economy would increase the capital-
labor ratio, pushing the return in the domestic economy below that on
world markets. The resource discovery therefore has no impact on domestic
non-oil income, consistent with unchanged growth of consumption,
.
C/C. Although these conditions may apply in some high-income countries,
they do not apply in developing countries implying that, should a developing
country follow this rule, it would not be optimal.
Pragmatic Conservative Rule: Bird-in-Hand Consumption
The PIH makes the case for smoothing consumption through time, but
implies that countries should borrow against future flows that enter
permanent income. A more conservative strategy is that countries place
resource revenues in a fund—possibly abroad—and only consume the
interest on the fund (Bjerkholt, 2002; Barnett and Ossowski, 2003). This rule
yields constant consumption once revenue flows have ceased, but leads to a
slow build up of consumption. For our hypothetical economy, this strategy is
illustrated by the dashed line labeled ‘‘bird-in-hand’’ in Figure 3. The strategy
yields a large increment in the consumption of future generations, but the
cost is that consumption benefits are pushed far into the future, in the
example, overtaking PIH only in year 20.
Conceptually, the PIH says consume the interest, but include the implicit
interest on the resource in the ground as well as the actual interest on the
resource once it has been converted into financial assets. The bird-in-hand
strategy says ignore wealth until it has been extracted and converted into
financial assets, and then apply the PIH (updated each period). It is a highly
conservative strategy that allows incremental consumption to reach its
maximum only once the resource has been depleted and thus entails high
welfare costs.
Optimal Policy for a Developing Country
Most developing countries are capital scarce, with domestic interest rate
above the world rate and access to world capital markets restricted, perhaps
by the country’s credit rating. Poor access to international finance is likely to
be compounded by a history of undersupply of public infrastructure and a
4
An implication of this result is sometimes known as the Hartwick (1977) rule. Saving the
whole of the revenue from a depletable asset will (if there is no population growth or technical
change) results in a constant path of consumption, that is, intertemporal egalitarianism.
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
95
poor investment climate. From this starting point, there is the potential of
making high-return investments and putting the economy on a growth path
that involves capital deepening, with the rate of return converging to the
world rate and, accompanying this, wages, consumption and income on an
upward trajectory. What are the optimal profiles of consumption and
investment (at home and abroad) out of natural resource revenue in such
developing economies?
There are two forces at work. One is that developing economies are still
converging to a higher level of consumption and income per capita.
Consumption is therefore currently low and on a rising trajectory. This is a
force for increasing consumption immediately—that is, using some of the
revenue for poverty alleviation. The other is that the rate of return in the
economy is high—a force for investing, which in turn will lead to growth of
the economy and thus to higher consumption in future. The efficiency
condition (Ramsey equation), rþ.
C/sC¼r
D
, has high values on both sides
of the equation. Now the optimal response to our hypothetical resource
revenue flow can be shown to be given by the curve labeled ‘‘optimal’’ in
Figures 3(a) and (b). The full analysis underlying this curve recognizes that
investment can take place in three sorts of assets: foreign assets (or debt
reduction), public infrastructure, and private capital stock and maxi-
mize social welfare (Ploeg and Venables, 2009). The optimal consumption
increment illustrates several points. There is a substantial jump in consump-
tion at the date of discovery. However, this jump is not as large as in the PIH,
because of the presence of high-return investment opportunities, both in the
Figure 4. Investment and Relative GDP Growth
Paul Collier, Rick van der Ploeg, Michael Spence, and Anthony J. Venables
96
domestic economy and in paying back foreign debt. Once resource revenue
starts to flow, there is a large increase in investment, this taking the form of
both lower public debt and an increase in public infrastructure investment.
Both these factors make private investment more attractive, so there is an
increase in the private capital stock and consequent increase in income
and wages. This finances the rapid growth in the consumption increment that
is illustrated in Figure 3(a), while enabling direct public transfers to
consumption to fall sharply.
The balance between consumption and investment depends on the return
that can be earned on investment of the resource revenue. If r
D
is high, then
the initial jump in consumption is small. Instead, resources are devoted to
investment and the output which this generates puts consumption on a
rapidly rising path, so the Ramsey equation, rþ.
C/sC¼r
D
, is satisfied.
Conversely, low r
D
means that the initial jump in consumption should be
relatively large; there are few good investment opportunities, so consumption
jumps up but can then only grow slowly.
5
The important point is that it is the
presence of high-return investments that can put the economy on a path of
growing income, wages, and consumption that is crucial to the consumption-
investment decision.
Looking beyond the point at which the resource flow stops, we see that
the consumption increment and asset increment are both positive, but
asymptotically converge to zero. The consumption decision therefore
involves saving some of the benefits for distant generations, but does not
involve establishing a savings fund to support a permanent increase in
consumption.
6
Instead of building up an overseas fund, the resource wealth
has been used to bring forward the development of the economy, this giving
higher consumption at future dates, but with the increment steadily declining.
The asset story corresponding to this optimal case is in Figure 3(b). The
curve is the increment to net national asset holdings, but does not include
private foreign investment in the economy. Initial consumption is funded by
borrowing (as in the PIH, but at a somewhat lower level), which is then run
down as assets are accumulated during the period of revenue flow. At the end
of the period of revenue flow the incremental assets (those on the optimal
path with resource revenue as compared with the path without such revenue)
are gradually run down as the economy continues on its growth path.
The message from the socially optimal path is therefore an intuitive one.
Immediate consumption for the current relatively poor generation is optimal,
but so is investment to put consumption on a steeply rising path. The best
way to achieve this is by investment in the domestic economy which
essentially brings forward the economy’s growth trajectory, benefiting all
generations. This contrasts with accumulating revenues in an SWF, although
5
And if r
D
¼r
we return to the world of the permanent income hypothesis.
6
Only if the resource discovery is very large will it also be optimal to build up a permanent
savings fund which will be smaller than under the permanent income hypothesis.
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
97
as we will see in the next section some accumulation of foreign assets is
desirable for smoothing volatility in revenue flows. The rate of return on
domestic investment is the key variable.
Public Infrastructure and Private Investment
The discussion of the previous subsection was couched in terms of aggregate
domestic investment. What form should this investment take? A full answer
requires disaggregation to the level of individual projects, but some
important points can be made about public infrastructure and its role in
promoting private investment.
One prominent feature of many of the countries in the developing world
with natural resources is a pattern of underinvestment in the public sector, in
tangible and intangible assets that are public goods, prominently in edu-
cation, infrastructure, and capacities associated with effective government
and economic management. This deficit leads to a situation in which the
economy is uncompetitive with respect to global alternatives and hence the
diversification of the economy and its exports is stalled. High growth
countries invest 5 to 7 percent of GDP per year (over and above expenditures
on basic education) in incremental education and infrastructure. Most
countries with slow growth invest only around 3 percent.
The leverage associated with making the investments associated with
increasing productivity and jump-starting the sustained growth dynamics is
very high.
7
Suppose for example (relying on data from high and low growth
cases) that an incremental 5 percent of GDP is devoted to public sector
investment in an economy growing at 3 percent, and that the incremental
investment enables (in conjunction with complementary policies) an
increment of 4 percent growth as a result of enhanced private sector
investment incentives and increased competitiveness in global markets. The
graph below shows the two growth paths for GDP net of the incremental
public sector investment over a 35-year time horizon. Manifestly, this pattern
of investment, if it works, would dominate any alternatives. The incremental
growth would likely involve a concomitant increase in private investment and,
because this would be financed by additional savings, it would be at the
expense of consumption. This is a choice that households and businesses make
in an environment which offers a high rate of return on investment: an
environment in part created by the complementary nature of much of public
sector investment. Even if one nets out the private sector investment to
focus only on consumption, the case for the growth-enabling public sector
investment remains strong. To see this, suppose that in addition to the 5
percent (of GDP) increment in public sector investment, there is an addi-
tional 20 percent of GDP increase in private sector investment.
8
Counting
7
This section draws on Commission on Growth Development (2008).
8
For this calculation, we ignore the contribution to private sector investment from foreign
sources. Foreign direct investment would be one category.
Paul Collier, Rick van der Ploeg, Michael Spence, and Anthony J. Venables
98
both incremental public and private sector investment, the internal rate
of return is 18 percent. The payback period with no discounting is about 13
years. It is clear that a short time horizon or a very high discount rate is
required to make the low growth approach optimal. One can vary the
numbers and parameters but the basic pattern remains. It results from the
leverage that goes with enhanced returns and incentives for private sector
investment and employment, backed up by the global economy. To put it
differently, a sustained increment in growth will dominate natural resource
revenues in the long run. Therefore investments that increase the like-
lihood of accelerating growth will dominate other investments in terms of
social return.
These incremental investment options are of course not dependent on
there being natural resource wealth. But the evidence, as well as political
economy research and social choices considerations suggest that in poor
countries it is difficult to achieve the initial increase in public investment. Our
contention is that natural resource wealth can make the choice easier, in part
because it does not require the political system to handle the intertemporal
distributional aspects of an initial reduction in consumption. Of course, there
are many practical difficulties. The marginal return (private and social) to
capital is unlikely to be known with much precision. It is also true that
there are constraints to growth. One of them is diminishing returns at
some point to investment (as distinct from capital). Roughly this means that
the efficiency of capital formation diminishes if one tries to accumulate
too fast. Finally, there is the issue of effectiveness. It is not just the quantity
but also the quality of public sector investment that enables the high
returns. Committing the resources without the ability to target them pro-
perly will not produce the desired returns in terms of growth. Never-
theless, domestic investment, both direct public investment, and (to the
extent there is a funding deficiency for private investment) funding at
reasonable cost for private investment have high priority claims on resource
revenue streams.
III. Absorbing and Implementing Investment
So far, we have taken as given that domestic investment yields a high rate of
return. In a capital-scarce economy this is very likely potentially to be the
case: indeed, if it were not, the economy would be unable to develop.
However, the very fact that the capital stock is low may indicate that there
are problems in absorbing investment. It is possible that the return
on the existing capital stock and small increments to it is high, but that for
various reasons attempts to increase investment rapidly encounter severely
diminishing returns. Such concerns are often flagged by the terms
‘‘absorptive capacity’’ and Dutch disease (for example, Corden and Neary,
1982). Spending a windfall may encounter bottlenecks in various nontraded
sectors and be associated with temporary appreciation of the real exchange
rate. Bottlenecks can be avoided by imports but not all productive, human
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
99
and managerial capital can be obtained from abroad. Furthermore, the
government generally does not have complete control over the alternative use
of funds; in practice, it is usually operating indirectly, for example changing
tax instruments that influence the behavior of the private sector who
are likely to be the ultimate decision-makers. In the remainder of this section
we discuss these issues, addressing the ways in which policy implementation,
at the aggregate level, at the level of project implementation, and in choice of
spending channels, can mitigate potential problems.
Absorbing Investment: Aggregate Issues
Spending resource revenues in the domestic economy (either on consumption
or investment) raises demand for locally produced goods and services. A
major concern is that the economy’s response to such a spending boom runs
into diminishing returns, reducing the value of spending. The basic argument
is that steep supply curves—particularly for nontradable goods and factors—
mean that spending translates into higher prices and crowds out alternative
activities, rather than drawing more resources into use.
An easy case when this does not occur is the Keynesian model of
undergraduate textbooks. All supply curves in the economy are perfectly
elastic and extra demand can be met without changing any relative prices or
‘‘crowding out’’ alternative activities. An increase in demand draws
underemployed resources into use and raises income. Owing to multiplier
effects, the final increase in income is larger than the increase in demand.
Income will continue to rise until the increase in income (DY) equals the extra
foreign exchange supplied by the windfall (DR) divided by the marginal
propensity to import m, that is DY¼DR/m.
Developing countries typically have unemployed (or underemployed)
resources. Can they hope for real income growth several times larger than
the resource revenue, in line with this view of the economy? In practice,
supply curves are not horizontal, neither at the aggregate nor at the
sector level. Hence, supply responses are dampened as prices rise and other
activities are crowded out by resource-funded spending. Often, the first
sector in which supply problems show up is the construction sector.
Resource-funded infrastructure investment might coincide with private
sector resource-related investment (for example, office construction)
leading to a construction boom and a rapid increase in the price of non-
traded inputs. As a consequence, the purchasing power of public expenditure
is reduced and this brake on infrastructure investment creates other
bottlenecks in the economy—in road capacity and traffic congestion for
example. Sector effects aggregate into economy-wide changes in relative
prices including higher wages and a higher price of domestic output as
a whole relative to the price of foreign goods. This shows up as a real
appreciation of the currency, and is the basis for the Dutch disease
and crowding out of nonresource exports (for example, Corden and Neary,
1982).
Paul Collier, Rick van der Ploeg, Michael Spence, and Anthony J. Venables
100
Are these effects a matter of concern for government and a basis for
policy intervention? After all, a steep supply curve may just be a fact of
economic life and does not of itself constitute a market failure. One frequent
cause of concern is that the activities crowded out are particularly valuable.
The Dutch disease argument is that private sector exports are crowded out by
resource-funded spending and that these activities are of particularly high
marginal social value. The basis for this may be external economies of scale
arising from learning by doing or from pecuniary externalities that support
the development of fast growing clusters of activity (for example, Wijnbergen
van, 1984; Sachs and Warner, 1997). In that case, a temporary decline of the
potential growth engine of the economy—the traded sector—will lead to a
fall in the rate of economic growth and thus to a loss in output. However, if
domestic spending of resource revenues is concentrated on public investment
that is complementary to these private sector activities—such as improve-
ment of productive infrastructure or labor skills—then these adverse effects
are mitigated and may even be reversed.
A second point is to do with the factors that determine the shape of
supply curves, both of individual sectors and in the aggregate. The fact is that
supply curves are often steeper than they need be due to inefficiencies in the
supplying sectors. What are the factors that hinder drawing new resources
into a growing sector? They include regulatory or other barriers to setting up
new firms, delays and costs in importing capital equipment, labor market
regulations that make it difficult to hire labor and the legacy of previous
underinvestment in, for example, labor skills. This standard list of factors
determines the investment climate, but their importance is amplified in the
context of a coming spending boom.
Options for Spending
although the ultimate decisions are on consumption, investment, and the
actual investment projects undertaken, many of the choices faced by
government appear rather different as they are on intermediate spending
channels rather than final projects. Broadly speaking, there are four channels
through which the government can allocate resource revenues. They can be
distributed to the private sector through citizen dividends or through the tax/
benefit system. They can be use to increase public spending, either on public
consumption or the construction of public assets. They can be retained as a
government financial asset but lent on to the domestic private sector, either
by government lending or lower public debt. And finally, they can be retained
as a government financial asset and lent to foreigners, by foreign reserve
accumulation or establishing an SWF. These alternatives vary in three
fundamental ways. Who gets ultimate ownership of the resource revenue and
hence control of the macro level time path of spending from this revenue?
Who gets control of the micro level spending detail—the choice of project?
How do they map into the overall balance between consumption and
investment?
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
101
Table 1. Government Choices: Impact per $1 of Revenue
Resource
revenue
Consumption Investment Balance Sheet
Private
consumption
Govt.
consumption
Private capital
stock
Public capital
stock
Foreign
assets
Private
assets
Govt.
assets
1. Tax cut/transfer 1 c01c001c0
2. Public spending 1 0 g01g001g
3. Domestic lending/debt
reduction
1z0g(1z)0(1g)(1z)z1
4. Foreign assets/SWF 1 0 0 0 0 1 0 1
Accounting identity RC
p
C
g
=I
p
þI
g
þI
F
=A
p
þA
g
Note: c—share of consumption from tax cut; g—share of consumption in government spending; z—share of consumption in private response to
government debt reduction/lending; C—consumption, I—investment, A—change in assets; subscript p—private, g—government, F—foreign; sums
across each row of the matrix satisfy the equation given in the bottom row. SWF=sovereign wealth fund.
Paul Collier, Rick van der Ploeg, Michael Spence, and Anthony J. Venables
102
Table 1 outlines these alternatives and some of their direct implications.
Alternative 1 is distribution to the private sector, through lower taxes or
social transfers. In this case, the government retains no ownership of the
resource wealth and consequently has no macroeconomic control over
spending once the transfer is made. This alternative also decentralizes the
microeconomic detail of spending to private citizens, rather than seeking to
implement projects through government ministries. Transfers will typically
induce both private consumption and investment, and we denote the increase
private consumption c(the marginal propensity to consume). The remaining
fraction 1cgoes to investment which adds to the private capital stock and
becomes a private sector asset.
Public spending, alternative 2 centralizes control, both at the macro level,
and the micro level of project design and implementation. This too will
typically be some mixture of current (fraction g) and capital spending, the
latter part adding to the public capital stock and becoming a government
asset or possibly adding to the human capital stock when it is spending on
education or health care.
The third alternative is for the government to retain the revenue as an
asset, but to lend it on to the domestic private sector to spend or invest. In
this way the government retains control of the macroaggregate, but
decentralizes the microeconomic detail to the private sector. This could be
new lending—for example, through a development bank—or the reduction of
existing domestic government debt. The private sector response will be to
consume fraction zand invest 1z. It is possible (in this and also in case 1)
that some of the private investment takes the form of acquisition of foreign
assets, so only fraction ggoes into the domestic capital stock, the rest being
invested abroad. Notice that in case 3 the government’s balance sheet has
improved, either by paying down domestic debt or through its financial
claim on new lending. To the extent that the private sector increases its
consumption, its asset position will deteriorate. Finally, in case 4 government
simply acquires foreign assets (or pays down foreign debt), this having no
direct impact on the domestic private sector and including the case of
investment in an SWF.
9
9
Note that the taxonomy links the discussion of resource revenue to that on scaling up aid
(Gupta, Powell, and Yang, 2006). In IMF terminology a foreign exchange windfall is 100
percent ‘‘absorbed’’ if it is matched one-for-one by an increase in the nonwindfall current
account deficit. Thus, cases 1 and 2 are 100 percent absorbed, case (iii) 1–(1g)(1z)
absorbed, and case 4 zero percent absorbed. A windfall is 100 percent ‘spent’ if it is matched
one-for-one with the nonwindfall fiscal deficit. Thus, alternatives 1 and 2 are 100 percent
spent, while alternatives 3 and 4 are 0 percent ‘‘spent.’’ Each of these alternatives has wider
implications for the economy as a whole.
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
103
Transferring the Absorption Problem to the Private Sector through
Citizen Dividends
One view of the optimal way to handle resource revenues is that they should
be handed to private individuals through citizen dividends and, if
government needs to raise funds for public expenditure, it should do so by
taxing back some of the dividend (that is, government should put 100 percent
of funds through route 1 of Table 1). Some areas have limited citizen
dividend schemes (such as Alaska and Alberta) and it is generally the case
that taxes in resource-rich regions are somewhat lower than they otherwise
would have been. What are the pros and cons of transferring the proceeds
directly to private individuals?
The main advantage is that, in countries with bad governance, it is
important to get funds out of the reach of government as rapidly as possible,
as has been argued for the case of Nigeria (Sala-i-Martin and Subramanian,
2003). This argument, though correct, is of doubtful relevance, because the
countries with the worst governance are unlikely to implement such a
scheme, and those most likely to implement it have least need of it. The issues
can be set in somewhat wider terms, via the argument that building state
accountability requires taxation. Some authors argue that bargaining over
tax is the basis of the social contract between the state and its citizens and a
key building block in the development of democracy (Brautigam, Fjeldstad,
and Moore, 2008). According to this argument, government should only
be able to spend the funds itself if it has taxed them back from the private
individuals to whom the revenue has already been given. Of course, this
has a disadvantage of administrative complexity as there are two layers of
government process, initial distribution and then taxation.
The second advantage is to do with the microeconomic detail of
spending. Private individuals are much better at identifying investment
projects than government officials, and have sharper incentives to implement
them well and make sure they succeed. Underdeveloped credit markets mean
that many high-return investments do not get undertaken, and putting cash
in the hands of individuals may remove credit constraints and cause such
investments to be made. This argument is supported by the evidence that
agricultural-based resource booms have had much more positive effects than
booms in ‘‘point resources’’ such as minerals or oil, in part because individual
farmers have increased investment in their small-holdings.
There are some counterarguments. The first is to do with the fundamental
problem of the intergenerational distribution of the benefits. Will private
choices lead to the optimal time profile of consumption vs. investment that
we discussed in section III? Individuals currently alive may give too little
weight to future generations and therefore invest too little (cis too high in
Table 1). Put differently, the SDR that society uses should be less than
market rates of return, and less than that suggested by studies of individual
behavior. This may be exacerbated if people overestimate the size and
duration of the revenues. Society therefore has an obligation to increase
Paul Collier, Rick van der Ploeg, Michael Spence, and Anthony J. Venables
104
savings rates by direct government action, and should not accept the pure
outcome of individual choice. The argument has particular force for the
proceeds of a resource windfall, which the current generation has no
particular claim to ‘‘own’’ any more than does any other generation.
Furthermore, the timing of individual spending decisions might contribute to
short-run booms and loss of macroeconomic stability, because private
individuals do not internalize the effects of their decisions on prices and the
level of activity.
Even if individuals wanted to save at a sufficiently high level, they would
not necessarily do so by undertaking their own investment projects.
Efficiency therefore requires an effective system of financial intermediation
which both rewards depositors and identifies investors who can best use the
funds. Without such a system, the argument that the private sector has better
information and incentives than the public sector is eroded. Of course,
cutting in the other direction, substantial cash transfers to citizens would be a
powerful force to promote development of a wider and deeper financial
system.
The arguments above were couched in terms of a ‘‘citizen dividend’’ or
pure transfer. In practice, transfers to the private sector are likely to take
place through adjustment of taxes, subsidies, or social protection schemes,
each of which has to be evaluated on its own merit. Recent empirical evidence
suggests that for each $1 of hydro-carbon resource revenue accruing to
government, domestic tax revenue is reduced by around 20 cents (Bornhorst,
Gupta, and Thornton, 2008). Resource revenues provide an opportunity for
reducing distortionary taxation that may have a negative impact on eco-
nomic activity, but it also provides the opportunity for maintaining highly
inefficient subsidy programs. For example, fuel subsidies may look politically
attractive in an oil-rich country, but are no less distortionary simply because
the country is oil rich. Social protection schemes have many advantages,
particularly in so far as they are associated with private sector accumulation
in either human capital (for example, transfer programs conditional on
school attendance) or physical capital (for example, by allowing farm assets
to be retained during an economic downturn or drought).
The balance of these arguments is country and expenditure channel
specific, but some broad conclusions can be drawn. It is important that some
fraction of revenues get into citizens hands quite early on. As we argued in
Section II, it is important to raise consumption, and it is also likely that
these flows would finance some high-return private investments. Risk of
large-scale theft of revenues is diminished and, perhaps most importantly, it
establishes the principle that the resource belongs to citizens, and is being
used for the benefit of citizens as a whole, rather than for a small elite. But
while these are arguments for the transfer of some fraction of revenue to
individuals, it is not an argument for the transfer of all of it. Private
individuals’ choices alone will not lead to an efficient profile of consumption
or spending, and there are pressing needs for direct investment in public, or
publicly funded, assets.
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
105
Transferring the Absorption Problem to the Private Sector through Public
Lending and Debt Reduction
Public lending (Table 1, alternative 3) is an instrument that puts the micro-
management of projects into the hands of the private sector, while retaining
control of the macroaggregates at the central level. This could take the form
of new government lending or the reduction of domestic debt.
Levels of government debt held domestically in African countries are
generally quite low relative to GDP but large relative to the banking sector,
amounting to an average of 25 percent of total commercial bank deposits.
What then is the effect of reducing the availability of government bonds? It
should reduce domestic interest rates and induce asset holders to acquire
other assets. Ideally this would be domestic assets, although the extent to
which this occurs depends on investment opportunities in the domestic
economy. One important mechanism may be that a reduction in government
debt deprives commercial banks of the easy option of simply lending to
government, and thereby induces them to be more proactive in seeking out
other lending opportunities.
What is the empirical evidence on the relationship between government
debt and lending to the private sector? Evidence suggests that the response of
private sector investment might be quite low, with one study finding that each
$1 decrease in domestic debt was associated with a 15 cent increase in lending
to the private sector.
The other side of debt reduction is new government lending through
institutions such as development banks. Unfortunately, the historical record
of such banks has been extremely poor, although on a modest scale it may
be worthwhile for resource-rich countries to revisit and rethink this option.
One suggestion is for lending for residential construction.
Scaling Up Public Spending
Hence, realistically, if the resource revenues are to be used substantially for
domestic investment, there is no alternative to this being led by the
government. There is indeed considerable scope for radically higher levels of
public investment in Africa. The Commission on Growth and Develop-
ment (2008) has suggested that the share of public spending devoted to
infrastructure by African governments is markedly too low. Infrastructure is
complementary to private sector investment, so benefits accrue directly and
also indirectly via increased private sector activity.
Linking public expenditure of resource revenues to development has both
macroeconomic and microeconomic components. The macroeconomics of
public spending concerns the capacity to manage change, the balance
between public consumption and investment, combating Dutch disease,
and linking spending to a strategic vision. Change is demanding and so if
spending rises too fast the processes of decision and implementation will
inevitably deteriorate. Hence, a wise macroeconomic strategy is to impose a
ceiling on the permitted rate of increase in spending. Incremental public
Paul Collier, Rick van der Ploeg, Michael Spence, and Anthony J. Venables
106
spending needs to be linked to a strategic vision of the realistic opportu-
nities facing the economy. Whether the economy is expected to grow
predominantly through e-services, agriculture, resource extraction, or
manufactures will imply different needs for public spending.
The microeconomics of public spending concerns ‘‘projects.’’ We use the
term ‘‘projects’’ generically, to cover investments and also initiatives to spend
through current expenditures. Why are the benefits of projects often low? Are
there issues that are particular to resource revenues? One problem arises due
to limited technical capacity and information. Ideally, the government will
have a stock of spending plans, each of them subject to rigorous ex-ante
appraisal—a social cost-benefit analysis. However, assembling a set of
prioritized spending plans and subjecting them to such analyses is hard in
principle, requiring information and technical expertise that is lacking even
in countries with a large government economic service. The problem is acute
in most developing countries. The other problem is to do with incentives.
Even if the information and technical skills are present, misaligned incentives
may cause decision takers to act in a manner that is socially suboptimal. One
extreme of this is corruption—incentives to steal or divert revenues. Another
example is rent seeking, occurring when effort is devoted to activities that
may be legal but are socially unproductive, involving a zero (or negative) sum
game to capture rents created by artificial scarcities.
Misaligned incentives arise easily in economies with partisan public
investment projects. In a country with well-developed patronage systems,
the government may be interested in investing primarily in their homelands
while the opposition is interested in projects in their home regions. In that
case the incumbent will over-borrow and over-invest in its pet projects in
order to tie the hands of potential successors who wish to invest in their own
pet projects. These political distortions are greater the larger the probability
of being removed from office, the more partisan investment projects, and the
bigger the illiquidity of the investment projects (for example, Glazer, 1989;
Beetsma and Ploeg, 2008). Effectively, governments prefer to put the windfall
revenues in illiquid partisan investment projects rather than to save them in a
liquid SWF. The key insight is that the challenge is not only to get a big
increase in public investment in many developing countries, but to also make
sure that it is the right type of public investment and that it is investment of
high quality. The past has witnessed many white elephant projects, because
it is the inefficiency of such projects that makes them politically appealing
as credible devices of redistribution (Robinson and Torvik, 2005),
which should of course be avoided. Misaligned incentives also come simply
from ‘‘market failures;’’ if people are unable to transact at prices that are
equal or close to social marginal valuations, then decisions will be
suboptimal.
These issues are particularly severe in the context of resource windfalls.
Large-scale revenues come on stream abruptly and are likely to be volatile.
Administrative systems lack the information and capability to scale-up
expenditures rapidly, and this leads to inefficient spending programs. This
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
107
Table 2. Classification of Accountability in Public Spending
Purpose and
Timing of
Scrutiny Top-down Bottom-up Peer Group
Internalized by
Workforce
Honesty: ex ante International competitive
tendering for public
investment projects
Civil society scrutiny of public
spending in Chad through
the college
Ethical norms set by an
association of doctors
Opportunities for
corruption resisted
due to integrity
Honesty: ex post Audit by Auditor General Exposure of public corruption
in the media
Peer group disciplinary
processes in
professions
Guilt and regret induce
confession and
restitution
Efficiency: ex ante Cost-benefit analysis of
proposed projects
Parliamentary approval of budget,
and Poverty Reduction Strategy
Papers consultations
Presentation of spending
plans by ministers in
cabinet
Pride in skill induces
high effort
Efficiency: ex post Evaluation of
completed projects
Comparison of benchmarked
performance of service delivery
in media
Comparison of
examination results
among headmasters
Failure induces an
effort to learn from
mistakes
Paul Collier, Rick van der Ploeg, Michael Spence, and Anthony J. Venables
108
argument obviously reinforces the case made for smoothing expenditure. It
also suggests that any initial jump in spending should be small, waiting until
capacity to spend efficiently is developed. Further, there is often a lack of
transparency surrounding resource revenues and this relaxes the disincentives
to misappropriate funds. The response is at several levels. Increasing
transparency and accountability limits the opportunities for theft of funds.
Responsible governments may also be concerned that they will be
followed by governments that are prepared to loot accumulated funds. It is
therefore (second-best) optimal for governments to use expenditures in ways
that are hard to loot, such as immobile capital investments or distribution
to citizens.
These concerns can be crystallized into the need for two distinct hurdles:
honesty and efficiency. In a well-functioning system honesty and efficiency
are enforced in multiple ways. Some work ex ante and are about how
decisions get authorized, while others work ex post and are about evaluation.
Enforcement is partly through top-down authority, partly through bottom-
up pressure from citizens and their representatives, partly through peer
groups, and partly through norms internalized by the public sector
workforce. Table 2 presents a classification of the 16 resulting mechanisms
and gives examples of each. The quality of public spending depends on all
these mechanisms, the balance between them depending on the needs and
opportunities of each situation. A key political challenge posed by a bonanza
in resource revenues is to upgrade these mechanisms as rapidly and as visibly
as possible.
Windfall revenues provide an opportunity for a quantum increase
in public spending which is likely to change both the composition of
public spending and the process by which it is undertaken, each of which
are manifestly political issues. Two important political pressures are
the bureaucratic tendency to defend existing budgets and lobbying from
special interests. If aggregate spending has only been increasing slowly,
the composition of budgets is likely to be inert due to bureaucratic defense
so, as needs change, the frozen composition may gradually drift further
from the ideal. However, one consequence of a frozen composition of
spending is that the returns to lobbying are low and so there is little
lobbying pressure. The net effect of budget inertia and weak lobbying
is likely to be that although incremental money is scarce it can be
well-used.
Both a sharp increase in the world price of commodity exports and the
discovery of natural resources are high-profile public events so that the
quantum increase in public spending is fully anticipated by political actors.
There is now plenty of incremental money free from the bureaucratic necessity
of maintaining existing budgets and so the return to political lobbying sharply
increases. Once lobbies have won spending increases, these tend to be locked in
by bureaucratic defenses against change. Realizing this, lobbies have an
incentive to devote resources even in excess of the current increase in revenues.
This generates the lobbying equivalent of the economics of a gold rush:
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
109
lobbies rush to stake claims to future income streams from the assignment of
rents.
10
Lobbying is subject to free-riding and so favors those components of
public spending that confer large benefits on small groups. It can take a
variety of dysfunctional forms, from financing election campaigns that create
political obligations, through strike threats by public sector unions, to
bribery of decision takers. In general, such an increase in political pressure
squeezes the use of public money for those purposes which benefit everyone.
The most generalized benefit is clearly to save the windfall in financial assets
and so this will attract the least political support, but more generally
lobbying will tend to reduce the return on incremental spending.
If citizens come to believe that the windfall will be captured by such special
interests, they might themselves pressure for second-best alternatives that at least
provide some benefits that are more widely distributed and highly observable.
Again, savings will not be favored because it is not observable. However, some
observable and widely diffused benefits might be poor uses of the windfall, such
as subsidized petrol or an increase in the national minimum wage.
Hence, the quantum increase is both an opportunity for increasing the
return on public spending, because it relaxes the bureaucratic constraint,
and a problem, because it generates a surge in lobbying which is likely to
reduce the quality of spending. The challenge for the government is publicly
to face down the lobbying surge. One approach is to establish explicit and
transparent new decision processes for natural resource revenues linked to
a clear vision of long-term development. While this runs counter to the ideal
fiscal principle of a fully integrated budget in which all revenues are pooled, it
might have superior informational properties. By spotlighting the new
spending, it makes scrutiny easier and signals to citizens that the windfall will
not be captured by special interests.
IV. Coping with Revenue Volatility
We have so far considered only one half of the problem: how to manage
depleting revenues. We now turn to the other half, how should resource-rich
countries cope with the notorious volatility of commodity prices? Volatility
of revenue is a prime reason why many developing economies with poorly
developed financial systems have miserable growth performance (for
example, Ploeg and Poelhekke, 2009).
Some of the fluctuation in resource revenues is predictable, due to
geology and depletion of resources. We argued above that the response to
this uneven time profile of revenues should be to invest primarily in domestic
assets in order to increase income in future. But much of the volatility is
10
Note that rent grabbing as a result of higher commodity prices is especially true for
capital-intensive mineral sectors such as oil, gas or diamonds, but not so for labor-intensive
resource sectors such as coffee, rice or banana where the higher prices lead to higher wages and
more productive activity (cf. Bo
´and Bo
´, 2009).
Paul Collier, Rick van der Ploeg, Michael Spence, and Anthony J. Venables
110
external, associated with global price volatility, and is profoundly un-
predictable, as illustrated by the recent collapse in global commodity prices.
Hamilton (2008), analyzes oil prices, and points out the high estimated
variance of price changes. From the standpoint of 2008Q:1 the predicted oil
price in 2009Q:1 was $115 with 95 percent confidence interval $62 to $212;
wide though this is, the actual price fell below $40. The price shocks are
compounded by the fact that resource discoveries and investments are highly
correlated with commodity prices. Hence, price crashes not only directly
lower existing revenues, but also reduce prospecting and investment in
extraction. Revenues can be hedged through future contracts, forward
markets, commodity swaps and other financial instruments, although these
are typically short- to medium-term instruments that are less useful for long
periods of low prices. To date only a few resource-rich countries (for
example, Mexico) have actually tried reducing exposure to commodity-price
risk by these instruments. Indeed, a useful role for the IMF might be to offer
support for the short- to medium-term use of such instruments, using its
specialized and expensive expertise in derivatives markets to substitute for the
lack of it in client governments.
In the absence of substantial hedging options, the analytical and policy
questions are: which other economic variables should fluctuate in response to
fluctuating revenues, and which should be stabilized? There are three main
options. The economy’s net foreign asset position can fluctuate, smoothing
the domestic economy. Consumption in the domestic economy can fluctuate,
passing the impact on directly to local consumers. Or domestic investment
can be varied, this creating a proportionately much smaller variation in the
domestic capital stock. We discuss each of these options in turn, and their
optimal combination.
Foreign Assets and Liabilities
A superficially attractive option is for government to smooth revenue
fluctuations by borrowing and lending in international capital markets. An
SLF would be set for investment when commodity prices are high and then
be run down when commodity prices are low. If there were perfect symmetry
in lending and borrowing then the expected size of this fund would be zero,
and volatility would be absorbed at little or no cost. But in practice, the
borrowing rate of many developing countries exceeds its lending rate, and as
we have seen the borrowing rates themselves can be extremely volatile. More
radically, when commodity prices decline, which is when countries would
need to borrow, they become less creditworthy, and may be shut out of
capital markets altogether. The global economic crisis of 2008–09 illustrates
this problem. This suggests that it would be efficient to build an SLF with
positive average value, so the country is on average a lender not a borrower.
How large should such a fund become? The fund would need to be
larger the greater the degree of prudence of the policymakers, the greater
the volatility of the revenue flow, and the larger the difference between
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
111
the marginal cost of borrowing and the marginal return to lending (or, more
generally, the distribution of marginal utilities of the resource revenue).
The standard approach to this question requires knowledge of the
preferences toward prudence, of marginal costs and benefits, and of the
stochastic process driving the volatility. Gelb and Grasmann (2008) look at
the size of fund that might be required not to fully smooth domestic
spending, but to maximize a benefit function in which there are diminishing
returns to spending. They find that it is optimal to save a full 80 percent of
the (incremental) revenues associated with a short (five-year) resource
boom.
11
This is a much larger percentage than is suggested by applying the
theory of precautionary saving in situations where there is no limit to how
much the government can spend efficiently.
12
However, there is a fundamental problem in that price booms and
crashes are relatively rare events; for example, because most resource-rich
economies gained independence there have only been two oil booms. Hence,
statistical analysis based on time periods of only two or three decades is likely
to be unreliable. If a longer time span such as a century is used, most of the
observations are a period during which the structure of the global economy
was so radically different that it is hard to believe that it has much pertinence
for forecasting the future. It may, therefore, be best to accept that resource
revenues are intrinsically subject to radical uncertainty.
These arguments make apparent the problem with building an SLF. If it
is to be large enough to offer a reasonable chance of successfully smoothing,
it implies that domestic spending of the revenue is extremely low. This
strategy has a high opportunity cost; as we argued in the previous section,
there is a higher return using revenues for investment in the domestic
economy rather than accumulating foreign assets. Essentially, the strategy of
substantially stabilizing the domestic economy by accumulating an SLF may
require such a large fund that it runs into the same problems as an offshore
11
They let the welfare loss of public spending be given by a quadratic, so that marginal
benefit of spending declines and beyond a certain level (say, 40 percent of nonoil GDP)
becomes negative.
12
If the interest rate and rate of time preferences are zero and the utility function displays
constant absolute risk aversion, then a back of the envelope calculation shows that the optimal
share of windfall revenue to save is eu
2
/2, where eis the coefficient of relative risk aversion and
uthe coefficient of variation of oil prices. The 95 percent confidence interval for the predicted
oil prices of Hamilton (2008) suggest mean oil price of $137 per barrel and a standard
deviation of $37.5, so that u¼0.27 over a one-year period. Given that a reasonable range for e
is 12, it is optimal to save between 3.75 and 7.5 percent of the windfall. If the windfall is
expected to last much longer than a year, oil prices are much more unpredictable as the
coefficient of variation increases with the square root of the length of the forecast period, so it
is optimal to have a larger share of the windfall as a precautionary buffer. In an intertemporal
context, the size of the precautionary buffers will have to be larger the more persistent shocks
to commodity prices are; furthermore prudence requires that oil depletion becomes much
more aggressive, especially if the country has substantial monopoly power on international
resource markets and attaches high priority to boosting public spending, thus departing from
the usual Hotelling rule (Ploeg, 2009).
Paul Collier, Rick van der Ploeg, Michael Spence, and Anthony J. Venables
112
SWF. Funds are not made available for domestic investment and consumption,
and benefits are pushed too far into the future.
Fluctuating Consumption
As we saw in Section I, much of the actual fluctuation in resource revenues
has fallen on consumption. This is costly. The usual consumption smoothing
arguments (the concavity of utility) are compounded by habit formation.
Households and government find it costly to cut back consumption once a
particular level has been experienced. Households may find it costly, because
habits form and utility suffers if they cannot be maintained. Governments
may find it costly, because they have entered into political commitments,
such as hiring public sector employees, which cannot readily be reversed.
Formally, this can be represented as utility in any period being dependent on
consumption relative to habit consumption C
H
(say, lagged consumption),
that is CoC
H
where indicates the degree of habit persistence. Estimates of
oare high (of the order 0.6) indicating that it is socially costly to raise
consumption when resource revenues come in and to bring down when
revenues dry up. If habit formation is potent then the implication for policy is
simply that consumption should never be required to decline.
13
Fluctuating Domestic Investment
The third option is that domestic investment fluctuates. Our long-run
analysis of Section II argued that it should be primarily domestic investment
that responds to resource revenues; does this analysis carry over to shorter-
run fluctuations? There are several arguments that suggest so.
The purpose of a flow of investment is to contribute to the capital stock.
This stock-flow relationship creates an inherent degree of smoothing between
investment and the output that it produces, so fluctuating investment is
consistent with a considerable degree of stability in productive capacity and
output. In even the best functioning economies, investment is more volatile
than other elements of national income, and coping with this volatility is not
a fundamental problem for such economies. Volatility of investment is also
likely to be less problematic than might initially appear likely, because the
strategy of using revenues for investment rather than foreign assets means
that investment as a share of GDP will be high in such an economy.
Of course, such fluctuations are not entirely costless, and the role for an
SLF is to smooth investment to the extent required to mitigate the costs of
fluctuation, but such an SLF need not keep the rate of investment constant.
Indeed, it is probable that what should really be avoided are sudden very
13
The IMF has amended its standard permanent income guidelines for the
nonhydrocarbon primary deficit of oil/gas-producing countries to allow for habit
persistence in public spending on final goods. This has been applied to calculate fiscal
benchmarks for Gabon (Leigh and Olters, 2006) and, more generally, for sub-Saharan African
oil/gas-producing countries (Olters, 2007).
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
113
large increases in investment. The accumulation of balances would then be
driven by the need to park savings in times of high revenues as much as by
the need to protect spending in periods of low revenues.
If volatility of investment is accepted, then this shifts the problem to what
should in any case be the heartland of policy analysis in a resource-rich,
capital scarce economy: how the domestic investment process should be
managed. The policy implication reinforces our previous conclusion that
government should focus on running a high long-term rate of investment.
Currently a typical investment rate for low-income Africa would be only 19
percent of GDP. An efficient use of resource revenues on the above principles
might roughly double this level. As discussed, this would require a very large
change in the structure of the economy, for example, implying a much larger
share for the construction sector, and much higher imports of capital
equipment with its related distribution channels. The need for investment to
bear the brunt of revenue volatility, which is the conclusion of this section,
fits well with an overall high level of investment. The larger is the level
of investment, the smaller, proportionately, is the required volatility in
investment, and so the easier it is to manage. Further, the phase of expansion
in investment opens up design options which can better accommodate
flexibility: for example, firms in the construction sector can structure their
new employment and finance obligations in such as way as to survive sharp
contractions.
An overarching policy implication is that SWFs and SLFs should not be
the focus of government attention. Following a resource discovery, or a price
hike, governments face a huge task of helping the economy to restructure to a
radically higher level and volatility of investment. An SLF is likely to be a
useful means of buying extra time during this adjustment, but overseas funds
become counterproductive if, instead of buying more time, they delay the
reconfiguration of absorptive capacity for investment.
V. Conclusions
The arguments discussed through the paper provide the basis for the follo-
wing conclusions. Consumption of resource revenues should be smoothed,
beginning early (perhaps before revenue flows) and certainly extending well
beyond the period of peak resource revenues. The mechanisms through
which this extra consumption is delivered are likely to be a combination of
lower taxation, social protection schemes, and above all higher income
coming from domestic investment and growth of wages and employment in
the economy.
The critical issue is therefore how to harness resource revenues for faster
growth. Potentially, the extra revenues enable faster growth of the domestic
economy both by increased supply of capital to the private sector and by
public sector investments that raise the productivity of private capital.
Increased supply of capital to the private sector comes from a range of
sources. Some may be at the level of the households, as people save some of
Paul Collier, Rick van der Ploeg, Michael Spence, and Anthony J. Venables
114
the proceeds of lower taxes or social protection schemes. Some may be
through asset substitution as reduced supply of government debt induces
people—and the commercial banks—to seek out alternative investments.
Some may possibly be through direct government lending if appropriate
institutions can be developed that are able to lend funds in an honest,
efficient, and accountable manner.
However, probably the more important source of increased growth and
private sector investment is the use of resource revenues to raise the marginal
product of capital, both public and private. Although a quantum increase in
the right type of public capital formation might normally be expected to
lower its productivity, in conditions where the existing public sector
performance is unsatisfactory a quantum increase can be an opportunity
for procedural change. The productivity of private capital can be increased
by the enhanced provision of public capital because the two are—or can be
designed to be—complementary. Public infrastructure can deliver lower cost
and better quality supplies of transport, communications, power, and human
capital provided one ensures that there is no inefficient partisan bias in
public investment and white elephants are avoided. Although there are
dangers of crowding out and Dutch disease effects, these can be offset by
public spending designed to increase the competitiveness of private sector
investments.
Lastly, we consider the implications of the global economic crisis for low-
income commodity exporters. An immediate result of the crisis was that
the global commodity boom abruptly ended. This gives rise to a tension
between the policy implications that follow from our structural and cyclical
analyses. The message from our structural analysis is that the government
of the typical low-income commodity exporter needs radically to increase
both its own investment and private investment as a share of GDP. The
message from our cyclical analysis is that investment should bear the brunt
of shocks, so that in response to a collapse in revenue it should be reduced.
In the context of the current crisis, how might these opposing messages
be reconciled? The answer is contingent upon how the government has
responded to the boom.
First, suppose that the government has largely saved the boom in foreign
financial assets, whether through an explicit fund, or simply by the
accumulation of reserves. The new information that the boom is over
reinforces the wisdom of having saved the boom revenues. The priority for
the government should now be to implement our structural agenda of
converting these financial assets into high-return domestic investment.
Second, suppose that the government has already used the boom to
increase domestic investment from a level that was initially too low. Now the
government has a choice: it can reduce investment back to its suboptimal
level, which would have the desirable effect of protecting consumption; or it
can defend the new more appropriate level of investment, and endure a one-
off phase of reduced consumption. Neither of these choices is attractive, and
in this situation there is a case for temporary international public financing,
MANAGING RESOURCE REVENUES IN DEVELOPING ECONOMIES
115
from the IMF or the World Bank. The loan could be repaid by freezing both
consumption and investment at these levels while the economy grows.
Finally, suppose that the government has used the boom to increase
domestic consumption. Unfortunately, in this case the increase in consump-
tion is unsustainable and it should be reversed as soon as possible before it
becomes entrenched into habits. There is no case either for reducing domestic
investment, or for international borrowing to defend consumption. There is,
however, a case for international public borrowing to finance an increase in
investment. Such an increase in investment would be timely in that it would
help to avoid a recessionary increase in unemployment induced by the decline
in consumption, as well as raising the level of investment toward a more
appropriate long-term level.
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