Central Asia's Energy Challenge: Overcoming the Natural Resource Curse

Editor’s Summary: During a recent conference in Almaty, Kazakhstan devoted to discuss key development issues facing Central Asia, one of the topics debated among experts from the region and from abroad was how to manage the “natural resource curse”, i.e., the widely observed phenomenon that developing economies blessed with ample natural resources tend to perform worse than those with fewer or no such resources. In this article, Johannes Linn explores why it is so hard for countries to manage their natural resources well, what has been the experience in Central Asia to date, and what might be suitable ways to manage future bonanzas.

In early June 2008, the International School of Economics, the Central Asian campus of the London School of Economics at the Kazakh British Technical University in Almaty, organized a conference on “Institution Building and Economic Development in Central Asia”. One of the topics debated was the threat of the “natural resource curse” hanging over Central Asian countries with substantial energy resource endowments. Azerbaijan, Kazakhstan, Turkmenistan and (to a lesser extent) Uzbekistan have large oil and gas reserves; Kyrgyzstan and Tajikistan have large hydropower resources, although much of their potential remains to be developed (read Water-Energy Links in Central Asia).

Three reasons are commonly given for the natural resource curse: (1) macroeconomic management difficulties, also know as “Dutch Disease”, when high resource export earnings lead to a real appreciation of the exchange rate which in turn discourages production in the other sectors of the economy; (2) volatility of earnings, mostly due to the high volatility of natural resource prices, and thus difficulties of maintaining stable national fiscal and debt management; and (3) negative impacts of high natural resource revenues on national institutions and governance. A key conclusion at the Almaty conference was that institutional, rather than economic reasons, are to blame for the difficulties that many developing countries have experienced in managing their natural resources effectively. A better understanding of the factors that explain the institutional dimensions of the problem therefore is essential.

One way to look at this question is to put oneself into the shoes of the President or Prime Minister of a country that has large energy resources. It is striking how many decisions she or he has to take in regard to the national energy wealth, how many opportunities there are to make the wrong decisions, and how many times she or he, and many others in the government and in the energy industry, may be tempted to engage in corrupt behavior in order to gain a share of the resource wealth for political or private benefit. Here’s a partial list of the most important decisions to be made:

Whether to extract the energy resource as quickly as technically possible, or to keep it in the ground for the future? In terms of economic efficiency the answer depends on the expected rate of increase in energy prices as against the expected rate of return on extraction now. However, the president will be pushed by many political and commercial interests to extract the resource more quickly rather than efficiently.
Whether to run the energy sector as a state monopoly, or to provide open access to international and national private investors? The rational answer to this question depends on the government’s capacity to manage the national energy state enterprise as against its ability to regulate and tax private companies, in a way that generates optimal national returns. But again the decision in fact may hinge on how hard and with what licit or illicit means key players push for one as against another particular set-up.
Whether to spend or save the national earnings from the energy resources? If the money is spent, it can be used for investment or consumption, including for subsidies; and whether to spend it in the public sector or channel it to the private sector, and if the latter, how best to do that. Again, there are plenty of opportunities for special interests to seek to bend the decision their way. If the money is saved, then it can be saved either at home or abroad, again involving major opportunities for poor decisions influenced by various interests.
Finally, who to sell the energy to? In landlocked Central Asia, much of the energy has traditionally been sold to or through Russia, but increasingly Central Asian governments want to widen their export market opportunities. This requires negotiations with many national and international parties and major investments in pipeline infrastructure – again an opportunity for side payments from eager buyers or contractors.

In short, in the face of large natural resource rents (or profits) there are many complex decisions that have to be made. Furthermore, there are many opportunities for decisions to be made not on grounds of optimal national economic outcomes but in response to pressure and inducements from special interests resulting in bad decisions from the perspective of the national interest. There is a dual impact from this: first, poor decisions mean wasted resources and hence foregone economic growth; second, the fact that there are so many opportunities for special interests to engage and great incentives to bribe or use other corrupt means to acquire a share of the resource rents for private benefit, undermines the integrity of national public institutions and creates a culture of corruption becomes endemic.

Four lessons from past experience can help a well-meaning President to take control of this decision making process and channel it into the right directions:

Think long-term, don’t yield to pressures to rush to development.
Whatever the path of extraction, focus on the most effective management along the path – public or private, as the case may be. Make a realistic assessment of capacities and risks – go where the greatest capacity is and where risks of mismanagement are least.
Manage the overall fiscal balance as well as the non-energy fiscal balance (non-energy fiscal deficit over non-energy GDP) carefully and for long-term stability.
And most importantly, introduce transparency and accountability in decision making and implementation; this will expose decisions to public scrutiny and debate and help ensure that there is less incentive and opportunity to mismanage the resources and undermine institutions.

It is instructive to consider the cases of Azerbaijan and Kazakhstan in recent years. Both have grown rapidly since 2000 and have so far been able to avoid a negative impact of the energy boom on their economies, although stresses are showing. Two complementary instruments have helped them manage better than most: the use of natural resource reserve funds (often also referred to as “oil funds”) and membership in the Extractive Industries Transparency Initiative (EITI).

Norio Usui of the Asia Development Bank recently reviewed the experience of the oil funds in Kazakhstan and Azerbaijan.[1] Kazakhstan ran large overall budget surpluses and kept non-oil budget deficits small (4% of non-oil GDP in 2006) and as a result has accumulated a large National Fund, as its oil fund is called ($21 billion as of February 2008) [2], while also paying off public debt. It generally did not use National Fund resources to support the budget or off-budget spending. Kazakhstan did however invest quite heavily in recent years in the diversification of its economy by its agricultural sector with large injections of budgetary support.[3] The recent banking sector crisis in Kazakhstan, which started in the second half of 2007, was principally the result of unchecked private sector expansion supported by an under-regulated banking sector borrowing excessively abroad, rather than of poor fiscal management of energy resources.

In contrast, Azerbaijan expanded its public spending dramatically and ran sizeable non-oil budget deficits (as much as 30% of non-oil GDP in 2006), with the State Oil Fund revenues funding not only budgetary but also off-budgetary spending. As a result the oil fund has remained relatively small ($2.5 billion, as of February 2008) [4]. In addition, the government borrowed abroad at a rate of 4% of GDP. Inflationary pressures have been rising.[5] Thus, while the oil fund instrument was helpful in Kazakhstan for effective fiscal management of the country’s energy wealth, this was much less the case in Azerbaijan.

The other mechanism which can help is membership in the EITI which Azerbaijan joined in 2003 and Kazakhstan in 2007. This international initiative aims to assist countries with managing natural resource rents in a transparent and accountable manner.[6] Azerbaijan, which has published seven EITI annual reports and “continues to lead the international community in adopting revenue transparency standards” according to the Revenue Watch Institute, an independent NGO devoted to monitor transparency in natural resource revenue management.[7] Nonetheless, according to Revenue Watch, more needs to be done to create transparent energy revenue and budget management systems.

Kazakhstan joined EITI only recently, and publication of its first EITI report in January 2008 according to Revenue Watch “is considered as a major victory for the EITI campaign in Kazakhstan”.[8] However, with various oil companies in Kazakhstan not yet reporting, with need for further enhancements in transparency of the National Fund and of budget practices, Kazakhstan still has a long way to go before reaching a degree of transparency and accountability in the energy revenue management that would give adequate protection against the potentially corrosive pressures on the country’s institutions typically associated with natural resource booms.

While the management of the energy wealth of Azerbaijan and Kazakhstan still falls short of the goals set by the countries and their outside partners, they have made significant progress and their experience holds important lessons for other countries in the region and elsewhere. The extreme mismanagement of national energy resources seen in Turkmenistan under the now-deceased President Sapamurat Niyazov would not likely have been possible with an oil fund and the EITI-supported transparency measures found in Azerbaijan and Kazakhstan. And for the future, as Kyrgyzstan and Tajikistan develop their hydro power resources, it will be crucial that appropriate transparency and accountability measures be adopted for the disposition of the revenue stream which will be generated by substantial energy exports. Kyrgyzstan is already a member of EITI, having subjected its gold mining sector to the rigors of this Initiative. Tajikistan, Turkmenistan and Uzbekistan are not yet members of EITI. An establishment of natural resource funds and membership in EITI should be high priorities for their governments.

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[1] Unless otherwise noted the data cited in this and the next paragraph are taken from Norio Usui. “How Effective are Oil Funds? Managing Resource Windfalls in Azerbaijan and Khazakhstan” ERD Policy Brief Series No. 50, ADB, Manila, December 2007, http://www.adb.org/Documents/EDRC/Policy_Briefs/PB050.pdf

[2] These figures are from IMF, Regional Economic Outlook: Middle East and Central Asia, May 2008, http://www.imf.org/external/pubs/ft/reo/2008/MCD/eng/mreo0508.pdf

[3] Richard Pomfret, “Central Asia in the 21^st Century”, Key Note Speech at the conference “Institution Building and Economic Development in Central Asia”, International School of Economics, Almaty, 5-6 June 2008.

[4] These figures are from IMF, Regional Economic Outlook: Middle East and Central Asia, May 2008, http://www.imf.org/external/pubs/ft/reo/2008/MCD/eng/mreo0508.pdf

[5] IMF, “Azerbaijan-2008 Article IV Consultation Preliminary Conclusions of the IMF Mission”, 1

March 12, 2008 http://www.imf.org/external/np/ms/2008/031208.htm

[6] See http://eitransparency.org

[7] For more information on EITI see http://www.revenuewatch.org/our-work/countries/azerbaijan-transparency.php

[8] See http://www.revenuewatch.org/our-work/countries/kazakhstan-transparency.php