Unlearning to learn: The path to diversification

Many countries have grown rich on natural resources, especially oil and gas, and have improved the overall standard of living of their citizens. Success stories include a diverse set of countries, including Botswana, United Arab Emirates, and Kazakhstan (with an equal number of contrasting failures). 

However, with lower commodity prices, many of these past successful economies need to adjust and find new sources of growth. They need to diversify their economies, which usually involves adopting new industries or entering new markets with existing products. Starting from market dominance in a few industries, or economic activities, the objective of diversification is to increase the share of other activities. Sometimes, a country may diversify its economy by anchoring new activities to the dominant one (such as an oil-dominant economy moving to petrochemical products), or to other existing but weaker activities. This is in line with product space dynamics, as articulated by economists Dani Rodrik and Ricardo Hausmann, whereby economies diversify by moving from existing products to related ones by leveraging skills, institutions, infrastructure, and business models associated with their traditional areas of activity.

Diversification involves learning about innovative products, new technology, and uncharted markets. But another agenda is equally important—the “unlearning” agenda. This is relevant for most stakeholders but specially for governments. Governments need to unlearn in order to learn.

Consider the case of natural resource rich countries. These countries typically have a dominance of natural-resource seeking and public procurement seeking investment, such as investment in oil extraction or refining, or building publicly funded roads and hospitals. Less common are efficiency-seeking investors, who seek to use countries as an efficient production base for export to other countries, thus helping them enter new export markets and link to global value chains.

In the traditional paradigm, countries choose among competing investors willing to either exploit rich natural resources or compete for public infrastructure projects. In the efficiency-seeking investment paradigm, it is the other way round—countries compete to attract investment. In a public procurement driven paradigm, government agencies draw up output specifications that companies fulfill. In the new paradigm the investors themselves will need to decide the specifics of their businesses in response to market conditions.

Understanding this requires a mindset shift. A paradigm shift in overall development strategy (i.e., toward diversification), leading to an efficiency-seeking foreign investment paradigm, means that governments need to view their regulatory role differently. The regulatory regime, both de jure and de facto, will need to provide investors with considerable freedom to operate in a dynamic market environment, while safeguarding legitimate societal objectives. This includes reexamination of how rules and regulations are written and how they are administered. In brief, the shifts in the development and foreign direct investment attraction paradigm requires a third paradigm shift—in mindset and behavior—leading to a different approach to regulation (see Figure 1).

Figure 1: Old versus new regulatory approach for diversifying economies

Diversification implies new activities and new ways of doing things, even if the move is to adjacent areas in the product space. Innovative companies are often small and lack the resources that large, established companies have to negotiate the regulatory landscape. A risk-averse, control approach to regulation thus discourages investors from entering uncharted territory.

Yet, such regulatory approaches are common in economies dominated by natural resources. As governments sought to ensure optimum use of natural resources or the efficient delivery of infrastructure and services funded by public procurement, they developed a risk-averse approach.  Driven by distrust of businesses, regulators developed an attitude of control and paternalism.

Elaborate licensing regimes are a reflection of this. Officials argue that these are needed in order to closely monitor investment trends and investors so that they do not indulge in “undesirable” activities and make wrong decisions that are costly to them and to society.

These tendencies are understandable, but they create the worst of both worlds. Businesses are burdened and investment is discouraged. At the same time, regulatory enforcement and other important tasks of government suffer due to the strain placed on the limited administrative resources of government. For example, investment promotion agencies often devote a highly disproportionate amount of resources to licensing and inspections functions, distracting attention and resources from their important investment promotion and attraction responsibilities.

Countries aspiring to diversify their economies will have to unlearn the old approach to regulations.   Governments will need to adopt a new approach, relying on smart risk management and a more nuanced method of regulatory governance, based on trust, i.e., the belief that the vast majority of investors have good intentions and do not require heavy scrutiny at every stage.

This is a difficult mind-shift to make but an essential one. Although arduous, unlearning is often a prerequisite to learning.