Rapid oil spending will strain Guyana’s meager human, capital resources; lead to disastrous results – Economist warns

Mar 19, 2022 News

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By: Terence M. Yhip (Ph.D)

 

 

 

 

 

 

 

 

 

 

 

Part 1-1 Introduction

If you want the perfect analogy in biology of efficiency and coordination—vital requirements for the public investments to succeed—look to the human digestive system for a gut understanding. The body uses nutrients in food for energy, cell repair and growth. But for all of these good things to happen without a hitch, the food must first be converted into nutrients for absorption.

Many “actors” with varied skills are involved, each performing a critical role in a long process. Imagine for a moment a Guyanese pepperpot and bread on a joyous Christmas morning, a tasty mutton curry on Eid-ul-Fitr, or hot aloo roti on Diwali. You’ve just had a meal, but hours later you experience excruciating abdominal pains. Your digestive system is shutting down, no longer able to do its job.

The analogy is apt for less developed countries that are attempting to use public investment in social infrastructure (e.g., health and education) and physical infrastructure (e.g., energy, ports and transportation) to drive economic development. But while the investment is necessary, it is not sufficient because other factors affect final outcomes. This is another way of saying that if it is true underdevelopment is just a technical problem, then merely filling the gaps will solve the problem and all will live happily ever after.

Absorptive incapacity, broadly speaking, includes all the things that cause public investment to fail: supply bottlenecks, bad governance or planning, bad institutions, bad politics, ethnic divisions, misguided policies, skill shortage, bad management and so on. In the last half a century, we have learned that rapid scaling up of public investment has tended to be counterproductive. The odds may seem discouraging to Guyana that has the means and the determination to develop but it faces a severe handicap due to its limited absorptive capacity.

To properly examine the circumstances before Guyana, I intend to tackle the explanation of this issue in three parts. Part 1 of this piece gives a brief background of public investment drivers in less developed countries with specific examples of oil-exporting countries. Part 2 outlines the problem of absorptive capacity, explains why attempts to initiate or accelerate economic growth have tended to fail. Part 3 focuses on Guyana and provides country examples of success and failure. And the final installment weighs the options to beat the odds of failure and examines the pros and cons for a “big push”.

Part 1-2 Background

In the 1960s, much of the literature on economic development focused on the baffling question of why foreign aid had failed so badly, an outcome that disappointed the proponents of Big Push theories (major pioneers were Paul Rosenstein-Rodan and Walt Rostow) in the 1950s and 1960s. In a nutshell, these models advocate a big push ─ a government-led, economy-wide and concerted investment drive ─ to lift countries out of poverty by initiating or accelerating economic development. Who can argue against that? However, Big Push with foreign did not generate development. Empirical work found that corruption, lack of good governance, and absorptive incapacity, were the chief culprits. To be fair, a parallel body of literature had argued that the failure of foreign aid was not the assistance itself but the form it took, and the question of whether it was “aid or raid” dominated public discussions for many years.

But by the mid-1970s, the “aid or raid” debate quickly faded into the background after oil prices surged and the resource windfall filled government coffers ─ particularly in Nigeria and Sub-Sahara Africa─ to overflowing. The windfall set off rampant public spending for consumption and investment, but, after the splurge, the countries found themselves in deep economic crises. The phrase “boom-bust” became the familiar description of these oil-dependent countries. Public attention quickly turned to the failure of public investment drives to kick start economic growth and development. Echoing the 1960s, the empirical literature found that the culprit was the same Unholy Trinity of (1) corruption, (2) lack of good governance and (3) limited absorptive capacity.

Part 1-3: Cases of counterproductive outcomes after a big push

How do we know a big push in public investment failed? Gross Domestic Product (GDP) growth per capita slowed or GDP per capita shrunk in the years after the splurge. Keep in mind that real GDP per capita is a measure of the standard of living. The chart below gives these perverse outcomes in several countries that embarked on ambitious investment projects between 1975 and 1978 after oil prices spiked in the early 1970s and created a windfall. As you can see from the chart, in all cases, GDP growth per capita worsened after the big push. Growth per capita dropped sharply in Trinidad and Tobago and Ecuador, whilst output per capita even dropped in Venezuela, Nigeria and Bolivia in the period following the investment booms. Venezuela spent 40% of the windfall on public investment.

Nigeria stands out because it invested so heavily, saw paltry results during the boom but a big decline after that. Bolivia’s investment drive was equally a disaster. The country suffered its first major economic crisis in 1978-1986 that started with external debt default in July 1978. What were the causes of the failures, not only in the 1970s but also in every decade after? This is the subject for Part 2 where we examine various factors that include the scale and pace of public investment and absorptive capacity constraints. Part 2 is the bridge to Part 3, the final installment.

PART 2: WHY ARE PUBLIC INVESTMENT DRIVES COUNTERPRODUCTIVE?

In Part 1, we saw that despite a big push in public investment in less developed countries, the outcomes have been counterproductive. Part 2 examines root causes, amongst which are scale and pace of public investments, absorption capacity constraints, perverse selection, principal-agency problem and perverse incentive. So: let’s begin with scale and pace. Guyana is starting out with a scarcity of public capital ─ power, transportation, ports, telecommunication, drainage and irrigation, sea defence, you name it. Ironically, the low capital stock is a plus, at least in theory, because the actual investment spending, which is the additional capital, is likely to be highly productive; however, as we will explain, if Guyana were to embark on a big push, or attempt to scale up quickly, it will run into various bottlenecks. The actual physical investment of building necessarily takes time and many projects implemented in a short time impose adjustment costs. In order to minimise costs but maximise net benefits, it becomes necessary to spread public investment over time.

More isn’t always better and, often, less is true for public capital spending because of diminishing returns. In the short term, many critical inputs are fixed in supply. For example, it takes 3-4 years to produce engineers. Imagine for a moment a government that is launching a series of big project with an undersupply of project managers, engineers, welders, heavy machine operators and so on. The most likely outcome is that the additional investment dollar spent will yield less and less value. For example, a big problem that Nigeria faced in its investment drive in the 1970s was massive port congestion, leading to rising costs, which is another way of viewing diminishing returns.

Nigeria’s experience brings us to the general problem of absorptive capacity. In order to implement projects successfully a country must have skilled and experienced workers for many varied tasks. In addition, a country must also have effective institutions to guard against corruption, make economically sound policies and decisions, hold people accountable and so on. Right now, Guyana has a severe skills gap that will take time to fill, even with reverse brain drain─ the Guyanese Diaspora going back home ─ and a programme for migrant workers that Kuwait, UAE and other Gulf states with small populations depend on. As for governance institutions it is probably fair to say that Guyana is just starting to have the mechanisms in place, prompted in part by rapid developments in the petroleum sector.

What else do we know about what may cause public investment drives to fall? First, the gaps in technical and management skills will hamper project screening and selection. Where political interference is endemic, bad decisions result. But, absent the independence, governments are more prone to downplay risks or costs but overestimate benefits. Second, the lack of an efficient (not top heavy) and effective screening process for public projects can lead to perverse selections, whereby chosen projects yield opposite results to the ones intended.

Another cause is principal-agency problem that results in conflict-of-interest. For example, think of bank mangers submitting extravagant claims for restaurant meals and first-class travel with family members. Such actions conflict with the interest of the owners (shareholders). Think also of public works projects where government officials and civil servants are filling their own pockets. Principal-agency problem crops up in projects that require many governments ministry working collectively. Human nature is such that when things aren’t going well, or when tasks are complex and demanding, the tendency is for people to “pass the buck”. Performance and quality suffer.

Finally, principal-agency problem appears in the form of perverse incentive problem where incentives lead to opposite results. For example, an unconditional cash transfer for poor families to spend on health and nutrition ends up in rum shops. Sometimes, governments are the victims of their own incentives. After the oil crisis in 1974 Trinidad and Tobago started to subsidise prices of gasoline, diesel and kerosene to reduce the impact on consumers, but over time the population understood the subsidy as a programme for sharing the country’s resource wealth. The artificially low prices encouraged illegal sale of subsidised fuel to foreign buyers. The contraband amounted to billions of liters, billions of dollars and moreover, imposed a cost for policing the crackdown. What’s more, the country can no longer afford the subsidies because of more pressing social demands on the government budget, such as medicine for the hospital, and pensions and grants.

PART 3: TOWARDS A STRATEGY FOR LONG-TERM SUCCESS
In this final installment, we’ll discuss the issue of optimal scale and pacing of public investment: Given the high failure rate in petroleum-rich countries, what are the chances of Guyana beating the odds? To answer this question, we must first examine two strategies: Front-loading with a rapid scaling up versus a spreading out the investment in a piecemeal fashion. Let’s begin by looking at the main hurdles Guyana must overcome in order to use its oil wealth productively. People who know the country ─ the land, the people, the culture and the history ─ would have no difficulty recognising the following constraints:

1. Capital-poor country;
2. Small population, just under 800,000, scattered over a wide area along the coast that is vulnerable to climate floods;
3. Severe shortage of workers with technical and managerial skills;
4. Inadequate infrastructure;
5. Nascent governance institutions;
6. Ethnic divisiveness and polarisation; and
7. Political dysfunction due to intense political rivalry, exacerbated by ethnic divisions, to manage the oil wealth.

Because of the big weight of the energy sector in GDP, even small changes in either the price of oil or in production cause disproportionately big changes in GDP growth rates and government revenue. Thus, the major medium- to long-term risks would include:

1. Exhaustion of oil and gas deposits;
2. Income instability due to wide fluctuation in both oil production and prices due to unpredictable events (e.g., the Russia-Ukraine conflict);
3. Long-term decline in oil and gas as the world moves away from carbon; and the likelihood that oil and gas income will end despite lots of the stuff still in the ground. The late Ahmed Zaki Yamani (1930-2021), Minister of Oil for Saudi Arabia for more than 20 years, is credited for saying in 2002: “The Stone Age didn’t end for lack of stone, and the oil age will end long before the world runs out of oil.”

Part 3-3 Arguments for front-loading and rapid scaling up of public investment

The arguments against piecemeal public investment or for an initial big push by government would include the following:

1. Since we do not know how long oil prices will stay high or how long world demand will last, the best course of action is to frontload and scale up infrastructure spending.
2. In order to bring a quick end to the poverty and the income inequality, Guyana must spend big and as fast as the oil money is rolling in. (Note: Bolivia tried this approach after the mid-2000s on the back of a natural gas boom, significantly alleviated poverty and income inequality, but could not sustain the programmes after the boom ended in 2013.)
3. There are positive spillovers resulting from undertaking many complimentary investments but in order to realise the positive externalities, a big-push is needed to ignite growth and create momentum. Investing in transportation and energy infrastructure, for example, lifts productivity and reduces unit costs. Agricultural productivity goes up, output prices go down. With backward and forward linkages, manufacturing benefits from plentiful and steady supply of cheap inputs. Think of a company making plantain chips or tomato ketchup. Across all sectors, the result is self-generating and cumulative growth.

The arguments against piecemeal public investment or for an initial big push by government would include the following:

4. Since we do not know how long oil prices will stay high or how long world demand will last, the best course of action is to frontload and scale up infrastructure spending.
5. In order to bring a quick end to the poverty and the income inequality, Guyana must spend big and as fast as the oil money is rolling in. (Note: Bolivia tried this approach after the mid-2000s on the back of a natural gas boom, significantly alleviated poverty and income inequality but could not sustain the programmes after the boom ended in 2013.)
6. There are positive spillovers resulting from undertaking many complimentary investments but in order to realise the positive externalities, a big-push is needed to ignite growth and create momentum. Investing in transportation and energy infrastructure, for example, lifts productivity and reduces unit costs. Agricultural productivity goes up, output prices go down. With backward and forward linkages, manufacturing benefits from plentiful and steady supply of cheap inputs. Think of a company making plantain chips or tomato ketchup. Across all sectors, the result is self-generating and cumulative growth.

Part 3-4 Arguments against front-loading and rapid scaling up

Suitable food, small bites at a time and taking time to chew, aid digestion and absorption. Echoing this fact, these points listed below argue for incrementalism or piecemeal public investments:

1. Front-loading will strain Guyana’s meagre human and capital resources. The absorptive incapacity will cause delays, raise costs, lead to diminishing returns and corruption, and also lead to perverse selection and perverse results.
2. A rapid scaling up of public investment will divert financial capital, physical capital and labour away from other productive uses.
3. To overcome the skills gap, Guyana must attract workers from outside. But the inflow will strain capacity in transportation, housing, medical services, electricity and other essential services, and cause inflation. Unless the exchange rate is freely floating or managed effectively, overvaluation and Dutch Disease are big risks.
4. Trinidad and Tobago launched a version of the big-push in heavy industrialisation, based on cheap oil and gas supplies. Momentum has stalled for these reasons: (a) The exhaustion of once abundant oil and gas,(b) the domestic prices are high (natural gas feedstock is no longer cheap), (c) Dutch Disease has been persistent, and (d) The assumption of backward and forward linkages in the economy has proved to be unrealistic.

Part 3-5: The case for a gradual approach

So, you’ve determined that the pressing needs are social development and physical infrastructure; you feel fairly comfortable that Guyana can finance its development without getting into domestic and debt; and now you’re faced with the big question: what is the best strategy for long-term success? First off, as a practical matter, we need to define, measure and track success over many years, mindful of the gestation of investment projects and the delayed productivity effects on the whole economy. Thus, the very first criterion of success is that the investments must make labour and capital more productive, resulting in a steady rise in total productivity of labour and capital combined. Second, the productivity improvements must translate into increased GDP, or higher income per capita and a reduction in income inequality. Third, the economy must be weaning itself from oil and gas, becoming more diversified. Standard indicators for each criterion are easy to calculate and it’s a matter of Guyana maintaining the relevant database.

British economist J.M. Keynes (1883-1946) wrote that in a world ruled by uncertainty, the future is unknown and unknowable. This underpins our preference for incremental spending over a splurge. Our bias is consistent with a Guyanese proverb, “one, one dutty build dam”─ every little bit adds up. A piecemeal approach makes room for observing and taking corrective actions; for monetary policy to achieve price and real exchange rate stability; for fiscal policy to grow the National Resource Fund, thus complementing monetary policy; for immigration policy to succeed in reversing the brain drain and attracting migrant labour; and, finally, for transparency and accountability institutions to take deep root and spread out. Success on these fronts is certain to boost Guyana’s international rankings in Perception of Corruption Index, and Ease of Doing Business Index. In this day and age when information is at one’s fingertips, it would be unforgivable if Guyana were to commit the very same errors that so many failed oil-rich countries have made. By contrast, Guyana can adopt best practices of relatively successful natural-resource rich countries, such as Chile and Botswana, and beat the odds.

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