Challenges of Commodity Economies

Stephen DeAngelis

October 31, 2008

Happy Halloween! This is a great holiday to remind us of scary things — like volatile commodity markets. I have occasionally written about the challenges faced by developing countries whose economies rely on primarily on the export of natural resources. In good times — when demand for those commodities is high — the money rolls in. In bad times — when the price of commodities fall — the economy also heads into a tailspin. One of the objectives of Development-in-a-Box™ is to help emerging market countries diversify their economies so that they can better weather market volatility. Simon Romero, Michael Slackman and Clifford J. Levy report on the dim near-term future facing three economies (Russia, Iran and Venezuela) that are heavily reliant on a single commodity — oil [“3 Oil-Rich Countries Face a Reckoning,” New York Times, 20 October 2008]. They write:

“As the price of oil roared to ever higher levels in recent years, the leaders of Venezuela, Iran and Russia muscled their way onto the world stage, using checkbook diplomacy and, on occasion, intimidation. Now, plummeting oil prices are raising questions about whether the countries can sustain their spending — and their bids to challenge United States hegemony. For all three nations, oil money was a means to an ideological end. President Hugo Chávez of Venezuela used it to jump-start a socialist-inspired revolution in his country and to back a cadre of like-minded leaders in Latin America who were intent on eroding once-dominant American influence. Iran extended its influence across the Middle East, promoted itself as the leader of the Islamic world and used its petrodollars to help defy the West’s efforts to block its nuclear program. Russia, which suffered a humiliating economic collapse in the 1990s after the fall of communism, recaptured some of its former standing in the world. It began rebuilding its military, wrested control of oil and gas pipelines and pushed back against Western encroachment in the former Soviet empire. But such ambitions are harder to finance when oil is at $74.25 a barrel, its closing price Monday in New York, than when it is at $147, its price as recently as three months ago.”

Not all emerging market countries have the luxury to pursue political agendas with the funds raked in from the sales of natural resources. They do face the difficult choices, however, when commodity prices fall. Russia, Iran, and Venezuela are fortunate. Their economies are not likely to collapse since $70/barrel oil is still twice as high as it was five years ago. Nevertheless, the abandon with which they have spent their petrodollars will probably come back to haunt them.

“Russia, Iran and Venezuela have all based their spending on oil prices they thought were conservative but are now close to the market level. Significant further drops could tip the three countries into deficit spending or at least force them to choose among priorities. A worldwide recession, which many economists say is likely, would worsen matters, dampening energy demand and holding down prices. … Daniel Yergin, chairman of Cambridge Energy Research Associates, a consulting firm in Cambridge, Mass., said oil states were facing something of a reckoning. Originally, he said, they saw the economic crisis as a problem mainly for the United States — but then oil prices went into free fall. ‘Now, the producers are experiencing a reverse oil shock,’ Mr. Yergin said. ‘As revenue went up, government spending went up and expectations of a continuing windfall led to greater and greater ambitions. Now they are finding how integrated they are into this globalized world.'”

The effect that oil prices have on each country is, of course, different. The authors note these differences beginning with Venezuela.

“Mr. Chávez has … used his oil money — in direct payments and through subsidized oil shipments — to win friends in the hemisphere and elsewhere, including President Evo Morales of Bolivia, who expelled the United States ambassador in La Paz last month, saying the envoy was involved in plotting a coup. Domestic spending in Venezuela has also surged, through the creation of a wide array of social welfare programs that furthered Mr. Chávez’s goal of building a socialist-inspired state — and suppressed opposition. The 2009 budget, based on $60-a-barrel oil, includes a 23 percent increase in government spending, to $78.9 billion. At $140 a barrel for oil, that was conservative. With prices now uncomfortably close to $60 a barrel, economists in Venezuela are expressing alarm over the government’s ability to pay its bills, including those for arms purchases. Venezuelans are already struggling with an inflation rate of 36 percent, one of the highest in the world. Mr. Chávez [claims] that the country could endure any oil price decline, citing its $40 billion in foreign currency reserves, though he then qualified his remarks by saying that oil prices at $80 to $90 a barrel would be sufficient for his plans. Still, fears of an impending economic crisis in Venezuela are increasing because of a lack of transparency in public finances and because the economy has grown far more dependent on oil in the decade Mr. Chávez has been in power, with seizures of rural estates weakening agricultural output and nationalizations scaring away foreign investors.”

Chávez has made a number of serious errors in judgment — the most serious of which is not trying to diversify Venezuela’s economic base and create jobs for its citizens. He had the opportunity (and may yet have another opportunity should oil prices rise) to invest wisely in building the necessary infrastructure and to reverse his disastrous socialist policies that have driven away foreign investors. If he doesn’t reverse course, Venezuela will be doomed to suffer the fate of all single-commodity economies.

The authors next turned to Iran and how the drop in oil prices is affecting that country.

“When President Ahmadinejad presented his budget to Parliament in 2007, the United Nations Security Council had already imposed economic sanctions on Iran because of its nuclear program. The president said it did not matter. ‘Even if they issue 10 more such resolutions,’ he said, ‘it will not affect Iran’s economy and politics.’ He was partly right. It hardly affected Iran’s politics. There was another resolution two months later, and another a year later — and still, Iran augmented its nuclear program, even as its economy was squeezed. One of the main reasons it was able to endure the economic punishment was the price of oil. Iran has the second largest known oil reserves in the world, and it has used them in the past four years as a political and economic weapon to defy and undermine the West while promoting its own agenda. Oil money helped Iran spread its influence in Iraq. Oil money helped it challenge Arab political dominance in the Middle East. Oil money helped spread its influence in Lebanon, through Hezbollah, and in the Israeli-Palestinian conflict, through Hamas. At home, oil money allowed Iran’s ideological hard-liners to preserve their monopoly on power, to buy political allegiances and to offset the fiscal damage of their economic policies. All that may now have to be recalibrated. … Even before the global economic crisis undercut the price of oil, Iran was gripped by an economic crisis. Now, inflation is running at 30 percent, according to the Central Bank. And this month, bazaar merchants, who wield significant political power, went on strike after the government imposed a value-added tax. Mr. Ahmadinejad’s way of dealing with the general economic distress has been to increase government spending, primarily through imports. But the International Monetary Fund said in August that Iran would face unsustainable deficits should prices for its oil fall to $75 a barrel. It is not expected that economics will force Iran to change its underlying ideology or long-term goals. Still, if prices stay depressed for long, it could mean a greater willingness in Tehran to find a compromise on the nuclear issue and, perhaps, a political shift that left Mr. Ahmadinejad vulnerable in June’s presidential election, analysts said.”

Iran is a tragic case. It is a country blessed with natural resources, an educated population, a long and glorious history, and a unique geographical location. As a result of policy decisions driven by ideology rather than economics, they are decades behind where they could be. As they look across the Persian Gulf at the UAE, Iranians must surely see “what might have been” when it comes to development and prosperity. Fortunately for Iranians, it is not too late. They still have all the pieces in place to become a more prosperous nation. Iran’s religious leaders feel an obligation to be the protectors the Shi’a branch of Islam, but they have pursued that role through nefarious means which has undermined the very religious values they have sworn to uphold. It’s not too late for them either. By joining the modern world and developing Iran’s enormous potential, the Mullahs would be in a much better position to serve as guardians of the faith.

Finally, the authors look at Russia and how falling oil prices are affecting its economy and increasing tendency to throw around its political might.

“On a winter day in 2006, Russia suddenly cut off the supply of natural gas to Ukraine, where a pro-Western government had come to power. The Kremlin cited a dispute over prices. But some Western officials said Vladimir V. Putin, Russia’s president at the time and still its paramount leader, was sending a message: Russia was willing to use its vast energy reserves to try to reassert the dominance it lost with the Soviet Union’s collapse. Two months ago, the muted reaction of some European nations to Russia’s invasion of Georgia seemed to indicate that Mr. Putin’s policy was working, some foreign policy analysts said. Europe had become dependent on Russia’s gas and could not afford to mount a strong challenge, they said. Now, however, with gas prices tumbling, this strategy has been thrown into question. Europeans may no longer be as intimidated, knowing that Russia is less able to pressure its customers. … Still, at least in terms of its domestic economy, [Peter Halloran, chief executive of Pharos Financial Group] and other experts said Russia was better positioned to weather lower prices than were many other oil and gas producers, because it had adopted conservative fiscal practices in recent years. The country deposited a significant portion of its oil revenues into two stabilization funds, which totaled $190 billion at the beginning of this month. The Russian budget is pegged to an oil price of roughly $70 a barrel — most revenues exceeding that have gone to these so-called rainy-day funds. The Kremlin also succeeded in recent years in establishing control over many of the pipelines that transport oil and gas in the region — an achievement that will endure despite the lower prices.”

The Kremlin has used these “rainy day” funds to help stabilize banks and the volatile Russian stock market over the past several months. Unfortunately, its foreign reserves have fallen dramatically as a result [“New Anxiety Grips Russia’s Economy,” by Andrew E. Kramer, New York Times, 31 October 2008]. From a high of around $600 billion in August, Russia’s reserves are now around $484 billion — with $31 billion having been lost this week alone. Like Iran, Russia is blessed with an abundance of natural resources and an educated population. Russian leaders learned a lot of lessons as a result of the “Asian Flu” that spread economic chaos to emerging markets in the 1990s. It was one of the countries hardest hit by that crisis. Russia has a more diversified economy than either Iran or Venezuela and should survive this latest storm even though they are going to have to delay some of their plans for the future.

The point of all this is that Russia, Iran, and Venezuela are much better off than most countries that rely on the sale of natural resources. Even so, they would be in even better financial situations were their economies not so dependent on oil. Oil has given them money and influence and when demand for oil falls so does everything that it props up. Every good economist preaches diversity for both individual and national portfolios. Enterra Solutions’ Development-in-a-Box approach can help countries better understand how they can diversify so that they are not whipped about by the volatility of commodity prices. There are no iron-clad guarantees that development will continue apace despite what the global economy is doing, but even with fits and starts, a diversified national economy has a better chance of thriving than one solely dependent on the fickle commodity market.