Published on Eurasian Perspectives

Economic diversification - the trillion dollar question: when and how?

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This blog is part of an ongoing conversation on diversification


When the World Bank helped Chad to receive oil revenue by supporting a 1,000km pipeline through Cameroon to the Atlantic in the early 2000s, it insisted on a far-too complicated revenue management system, which included stipulated payments into a ‘fund for future generations’. The management system did not survive long after the first tanker left the Cameroonian coast, a ‘ death foretold’. A Chadian official at the time explained it nicely: ‘We have been waiting for this oil field to be developed for 30 years. We are the future generation.’

When Phillips Petroleum came to explore for oil in the Norwegian North Sea, the foremost Norwegian petroleum geologist was so sure that nothing would be found that he promised to drink every drop of whatever Phillips produced. The country nevertheless went about creating a legal framework to manage the coming oil bonanza under strong government control, and the geologist never had to make good on his promise.

Nigeria is wholly misunderstood. It is not an oil country. It has as much oil as Denmark, when one takes into account Nigeria’s large population. We know of no study of the effects of the ‘resource curse’ in Denmark. The problem with Nigeria therefore is not its oil, but the lack of everything else. The country made two attempts at building sovereign wealth funds, but most of the money was transferred to private wealth funds of dictators.

Why do we present these anecdotes?

They highlight the nature of the ‘resource curse’: countries with good institutions make good use of natural resource wealth, while the obverse is equally true.

However, our take diverges a little from the conventional wisdom: it is certainly true that Norway was a strong parliamentary democracy when oil was discovered, but it did not have the legal and regulatory institutions to manage the oil boom. It developed them over time, as needs arose and circumstances changed.

When oil revenue started flowing in the early 1970s, Norway was a backwater with isolated farming and fishing communities connected by gravel roads during the summer months, and skis in the winter. Following the creation of strong institutions to manage natural resource wealth, it then invested its revenues in roads and human capital. It created a sovereign wealth fund, of sorts, in 1967, which was the Government Pension Fund.

It still invests exclusively in the domestic stock market and gives the Norwegian state a greater share of ownership of the economy than Yugoslavia had under President Tito. Norway only started a proper sovereign wealth fund with investment abroad in 1990, and it now holds a staggering $800 billion, or 1 percent of global stocks. Since 2006, it carries the name of Government Pension Fund (External) to emphasize the long-term saving function.

It is therefore hard to disagree with Hans Timmer’s  recent blog on ‘The Dutch Disease and Market Forces’, which concludes ‘if oil-exporting countries should regret one thing, then it should be that they did not invest more in education and institutions during the oil price boom instead of all the investments in real estate and other immobile factors’.

Hans poses the question of the right timing to execute a diversification strategy: should governments worry about diversification in good times, when capital inflows are abundant and moods are cheerful, or in bad times, with their backs to the wall and the risk of seeing a reversal in the prosperity gains achieved by a large chunk of the population? It would seem that no matter the option chosen, governments find their way into the same old jam.

The choice of investing in sovereign wealth funds should be based on a comparison between the marginal returns of investing in domestic assets (sometimes hard to measure) and the marginal returns of investing in foreign assets. Plausibly, the marginal return of investing in national assets declines with the level of development. In many developing countries, the marginal return of investing in health, education, infrastructure (and institutions, although it is harder to measure) is huge since they are starting from a very low base.

Spending domestically does not necessarily result in a huge real exchange rate (REER) appreciation, if spending lowers production costs and removes bottlenecks, rather than creating ‘white elephants’, or Zaha Hadid’s cultural center in Baku. Also, relative prices at a given moment in time do not take into account endogenous technological progress, which is what leads to the discovery of new products.

Endogenous technological progress requires institutions that provide the right incentives to invest in new ideas, as well as the capital (physical and human) that will make those ideas reality.

Based on historical experience, it is debatable whether a more favorable exchange rate alone makes a country more competitive and by how much. Look at Russia or Kazakhstan, which are among the most sophisticated oil exporters. Despite the recent sharp devaluation of their currencies, their exports are hardly booming. The reason? They simply do not have much to export. Their shirts are still a lot more expensive than the ones made in Vietnam and their more sophisticated products are simply of too poor quality to compete with Germany.


Because (i) they don’t have enough of the right skills to produce them and (ii) their domestic markets are not sufficiently competitive to allow for the emergence and survival of the most productive and innovative firms.

In sum, we should not overestimate the power of the real effective exchange rate, nor that of governments to engineer diversification by repatriating financial assets stored abroad when the oil price hits rock bottom. Ask the Russians. Despite the zen attitude of the population, reserve funds are being quickly depleted (according to some estimates, they may run out by the end of 2016) and the government’s anti-crisis plan still has to square the 1 trillion dollar question of how the economy can grow and diversify with low oil prices. 


Ulrich Bartsch

Lead Economist, Turkey

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