Precept 10

Precept 10

The government should facilitate private sector investments to diversify the economy and to engage in the extractive industry.

Using resource revenues to grow the domestic economy depends crucially on significant increases in private sector investment—from large-scale infrastructure to smallholder farms. Yet, encouraging sustained growth beyond resource extraction has been a problem for many resource-rich countries.

See Precepts 7 and 8 on the impact of large revenue flows into an economy.

First, without countervailing government action, large capital inflows may lead to an appreciation in the domestic currency, resulting in reduced competitiveness and a deterioration of domestic manufacturing and export sectors—a phenomenon known as "Dutch disease." If such consequences are left unaddressed, private investment in these export sectors may shrink. Furthermore, the cost of investing in other domestic sectors may rise. This can weaken economic growth and leave the economy more exposed to commodity price volatility since the extractive industry becomes an even greater share of the economy.

Second, to increase the growth impact of resource revenues, public investment must respond to private sector needs. This creates a key role for government to increase the domestic economy’s capacity to absorb resource revenues and leverage private sector investment. Working in partnership with the private sector is essential to the provision of complementary economic inputs: for example, government spending on schools and hospitals provides a more productive supply of workers for companies.

Establish an enabling environment for private investment

Using revenues primarily from its diamond industry, Botswana has consistently spent over five percent of its GNP on education since the mid-1970s. The result today is universal primary education and a secondary gross enrolment ratio of 82 percent, double the African average.
—United Nations Educational, Scientific, and Cultural Organization, 2012.

The government should provide an enabling business environment without targeting any specific industry. This includes reforms to improve the regulation of capital, land and labor markets; the provision of infrastructure and public goods; and social policies to raise the productivity of workers. In particular, reducing bottlenecks in the economy can lower private investment costs and improve the capacity of the economy to absorb further investment.

Small, low-income countries are often characterized by small markets dominated by monopolies and cartels, which can systematically elevate the price of capital and equipment, deterring investment. Active policies to encourage new entrants can help to dismantle these cartels. These policies might simplify the process by which businesses are established, or enlarge the market by integrating regionally and removing non-tariff impediments to region-wide marketing of imported equipment.

Two sectors merit special attention: construction and finance. In the construction sector, buildings and other structures are likely to be an important investment for urbanizing countries. However, importing bulky construction materials such as cement is prohibitively expensive, so businesses will be eager to source from domestic suppliers where available. Small economies with previously low investment often have high unit costs of construction, and a sharp increase in a demand for construction can result in these costs rising further. Working through the construction sector value chain and addressing bottlenecks, and dismantling cartels and monopolies in construction, can help to reduce these costs.

For those construction goods that cannot reasonably be produced domestically and must be imported, a reduction of specific tariffs can be helpful. While this may lead to a loss of customs revenue and protection for domestic suppliers, decision makers should weigh this against the benefits of higher public and private infrastructure investment.

A progressive financial sector is also important. As firms grow and look to increase their investment in the domestic economy, they will encounter two financial constraints. First, investment requires upfront capital. Second, as a firm grows, planned output for the year ahead will be higher than the sales achieved in the previous year, resulting in a shortfall in the funds required to produce future output. Therefore, firms will also require greater working capital financing. For both of these reasons, demands for funds (and the associated services) from the domestic financial sector can increase rapidly in a growing economy. Policies targeted at strengthening and expanding the financial sector can help to reduce bottlenecks; injecting public revenues into the financial sector can alleviate bottlenecks in the short-to-medium term while longer-term policy measures are put in place.

Decide whether to provide targeted support to business

Resource booms create both the risk of an over-dependency on the extractive sector, and the opportunity to promote the rest of the economy, diversifying away from extractives.

In most African countries, a lack of infrastructure is a major constraint on doing business, depressing ?rm productivity by about 40 percent.
—Escribano Saéz, Álvaro, José Guasch, and Jorge Pena, 2010.

Overall, the establishment of an enabling business environment, as discussed above, can support diversification by facilitating increased investment in a variety of sectors beyond resource extraction. In addition, government may directly promote specific sectors or industries, or promote domestic value addition in the extractive sector. However, such policies carry risks, such as the politicization of sector selection, and the emergence of uncompetitive, protected firms. Unwinding this protection can also be problematic if it creates powerful vested interests, and so it may be better to avoid such policies in the first place.

If the government chooses active policies despite these risks, it should consider two principles:

  • There should be a credible expectation that investment will attain long-run commercial viability. Investments that fail this test are likely to destroy rather than add value, and will drain public funds.
  • Government support should be linked to success, not failure. Government should avoid open-ended support packages. Support should involve credible criteria for termination in the case of continuing poor performance. Lobbying by interested parties is frequently an obstacle to reasoned termination, so government should make decisions at a high level and in consultation with a wide section of society—consumers and taxpayers as well as business interests.

Decide whether to use local content regulations

Extractive industries can provide the impetus for economic growth through demand for domestic goods and services, as well as through the transfer of international business knowledge. The government should implement policies that provide a general enabling environment for businesses and help enhance the quality of the labor force across industries to help the private sector engage with the extractive industry.

Where these general policies are not sufficient, government may consider enacting specific regulations on the amount of local content in extractive companies’ inputs. For instance, governments can require international companies to develop a package of local sourcing and knowledge transfer as a part of their bids for concessions or to provide services to concessionaires; or the government could stipulate such a package in post-award negotiation. Government may wish to protect domestic suppliers from global competition if they are not sufficiently competitive to supply the extractive industry, however, such measures should be temporary and linked to a defined plan for domestic suppliers to eventually compete on an equal footing.

The government may also wish to facilitate the transfer of technology and skills from extractive companies and their international suppliers to local firms. Training facilities, and investment in research and development, among other schemes, can enhance local business capacity to meet company demand. Such schemes may substantially benefit from close collaboration with the extraction companies themselves. Government may also enact minimum local employment requirements at the manager and employee levels, and strengthen these requirements with a system of monitoring and reporting, alongside penalties or incentives.

However, these local content policies are unlikely to be a replacement for policies to provide an enabling environment for businesses and workers, and should instead be implemented in conjunction with general economic reform. Moreover, the long-term sustained future of a local industry based on a depleting asset lies in continued resource discoveries, or in the eventual ability of local companies to compete in foreign markets. The government must be aware of this risk. While encouraging participation in or supply to the extractive industries, government should promote diversification of the economy from the outset. In this context, authorities must consider the types of domestic capacity that will be developed from "extractive experience,", so that they can then focus on those capacities that are transferable to other, more sustainable sectors.

Choose whether to encourage downstream operations.

Resource-rich countries should evaluate opportunities for downstream activities, such as petroleum refining. A country may face urgent unmet needs for energy and resources vital to livelihoods and economic activity, and extracted resources can provide an opportunity to meet those needs and support economic development. Governments sometimes consider domestic processing of resources a priority investment. Whether the government should promote domestic participation in downstream industries depends principally on weighing any savings on transportation to and from a foreign refinery, and other potential benefits, against potential downsides to state support for the domestic downstream industry. These include the opportunity cost of public funds used in highly-capital intensive processing plants; dependence on imported skills and equipment; and the potentially limited job creation relative to other industries.

For bulky commodities, or where there is significant local demand for the commodity, the case for developing downstream industries is stronger. Natural gas is particularly noteworthy because of its linkages to power generation, a prerequisite for economic development. Gas generally has high transport costs, and therefore has the potential to be a competitive supplier to local power generators. Gas-powered generation is also lower in capital intensity compared with alternatives such as oil, coal, and nuclear, as well as hydropower and other renewables; use of gas can also facilitate a transition to low-carbon energy technologies. In addition, a system to feed a domestic market ensures that excess gas resulting from oil extraction is used safely, efficiently and on an environmentally sound basis.

Further Precept Details