Is there a natural resource curse in finance?

The natural resource curse has featured prominently in discussions on why many developing countries fail to grow. This curse takes on many flavours — adverse exchange rate effects, underinvestment in human capital and institutions, political conflict and violence, to name just a few. What about the effect on the financial sector? The financial sector has been shown to have a critical role in intermediating domestic savings into domestic investment and in allocating scarce resources effectively, with positive repercussions for economic growth (Levine, 2005). The financial system should thus serve as an important absorption tool for windfall gains, such as arising from natural resource rents. Does it fulfill this role? Previous work has shown that financial systems are less developed in more resource-rich countries (Beck, 2011), but this could be driven by demand, rather than by a supply-side related curse.

In recent research, we address the causality challenge by gauging whether natural resource windfalls are associated with deeper financial intermediation, using a panel dataset of over 150 developed and developing countries over the period 1970 to 2008. Using a novel methodology to isolate exogenous changes in natural resource rents and applying structural VAR methods allows us to address concerns related to cross-country explorations of the relationship between natural resources and financial development and make statements beyond simply correlations.

Why would there be a natural resource curse in finance?

Theory makes contradictory predictions on financial development in natural resource rich countries. One can think that resource wealth has a positive impact on the financial sector: On the deposit and funding side, higher natural resource rents can result in higher deposit funding for a country’s banking system if they are saved domestically. They might also lead to higher loan demand, especially consumer credit, thus deepening the financial system. However, there are also arguments for a negative impact of resource wealth: windfall gains can lead to a shift of wealth out of the domestic financial system, either into foreign investment conduits and offshore sovereign wealth funds, or into non-financial wealth, especially in the case of inefficient financial sectors. In addition, the traded sector might suffer as natural resource rents lead to more resource extraction, crowding out of the non-resource sector and thus resulting in lower demand for external finance. Finally, the heavy dependence of the financial system on a sound institutional framework, including an effective contractual framework, can hamper financial deepening in countries where natural resource abundance undermines institutional development.

Isolating the exogenous component of resource rents

The literature has used different indicators to measure the reliance of economies on natural resources, ranging from the export share of natural resources in total exports to the importance of sub-soil wealth in a country’s total wealth and giant oil field discoveries. However, these indicators are based not only on exogenous geology, but also on exploration effort, technology and extraction costs and thus endogenous (van der Ploeg and Poelhekke, 2010).

We therefore focus on the price component of changes in resource rents, based on data from World Bank (2011). Resource rents are computed as total production times the world price net of unit cost of production and their changes can be split into (i) the log change in the Paasche price index of metals and minerals, with base year for prices (but not weights) set to 1970, to capture windfalls due to exogenous world price shocks, (ii) the log change in metal and minerals revenue (value of production) divided by the Paasche price index of metals and minerals, which indexes windfalls due to changes in production, and (iii) the log change in Paasche unit production cost index of metals and minerals, with base year for costs set to 1970. In our empirical analysis, we focus on the change in the country- and year-specific price index as a gauge of natural resource windfalls.

We relate annual changes in resource rents due to price, quantity and cost changes to changes in different indicators of financial development as well as macroeconomic indicators, using dynamic panel regression as well as VAR and structural VAR models, where in the latter we allow for feedback effects between deposit taking and lending by banks, inflation and GDP growth.

Our findings

Using a panel dataset of over 150 developed and developing countries over the period 1970 to 2008, we find

• a relative decline in the volume of financial sector deposits in countries that experience an unexpected natural resource windfall. Compared to countries with similarly booming economies as captured by total GDP growth, we find that those countries where the positive growth impetus is induced by an unexpected positive shock to the exogenous world price of its basket of natural resources experience a relative decline in private financial sector deposits;
• a relative decline in the volume of private sector lending, although the decline in lending is mostly due to the decrease in deposits.

We find that that these country level results hold across different types of deposits, they are confirmed with bank-level regressions and independently of bank characteristics, are robust to controlling for news about natural resource discoveries, to dropping major mineral exporters, and to the existence of sovereign wealth funds. However, there is one important differentiating factor across countries: our findings hold primarily for countries with less developed institutional frameworks and repressed financial systems.

If the resource wealth does not enter the financial system, where does it go and what is the macroeconomic effect? We find evidence

• that foreign assets and government deposits with commercial and central banks increase following a natural resource price shock;
• that the higher government deposits with commercial and central banks results in higher government consumption, but this in turn does not lead to more private lending.

Our results are not only statistically but also economically significant. Compared to the counterfactual of a country growing at similar speed, a doubling of commodity price inflation induces a relative decline of deposit growth by 3.4%, but increases relative growth of foreign assets by 9.6% and government deposits with central banks by 19.3%, which in turn raises government consumption but not private lending

These results clearly indicate that unexpected exogenous windfalls from natural resource rents are not intermediated and are consistent with the negative long-term relationship between the reliance of a country on natural resources and financial sector development as well as the government as major beneficiary of natural resource booms while at the same time undermining the financial intermediation process. They also send a powerful policy message – institution building and regulatory reform is even more important in resource rich countries, if the financial system is to fulfill its critical role in intermediating society’s savings for the benefit of long-term inclusive growth.

References

Beck, Thorsten (2011). Finance and Oil Is There a Natural Resource Curse in Financial Development? In: Rabah Arezki, Thorvaldur Gylfason and Amadou Sy (Eds.): Beyond the Curse: Policies to Harness the Power of Natural Resources, Washington DC: IMF, 81–106

Beck, Thorsten, and Steven Poelhekke (2017). Follow the money: does the financial sector intermediate natural resource windfalls. CEPR Discussion Paper 11872.

Levine, Ross (2005). Finance and growth: Theory and evidence. In P. Aghion and S. Durlauf (eds.), Handbook of Economic Growth. The Netherlands: Elsevier Science.

Ploeg, Frederick van der, and Steven Poelhekke (2010). The pungent smell of 'red herrings': Subsoil assets, rents, volatility and the resource curse. Journal of Environmental Economics and Management 60(1) 44–55.

World Bank (2011). The Changing Wealth of Nations: Measuring Sustainable Development in the New Millennium. Environment and Development. World Bank.