Windfalls and economic growth

The most prevalent cause attributed to poor rates of economic growth in mineral-rich countries is Dutch Disease—a term originally coined to refer to the short-lived problems that the Netherlands faced when it discovered huge gas reserves off its northern coast in 1959. Yet, the direct effects of export booms—whether due to a rapid rise in exports or commodity prices—is a common source of economic stagnation across mineral-rich states. Simply put, these windfalls lead to an appreciation of the real exchange rate (that is, the rate of exchange between currencies adjusted for inflation) by shifting production inputs (capital and labor) to the booming mineral sector and non-tradable sector (that is, retail trade, services, and construction), thereby reducing the competitiveness of the non-booming export sectors (for example, agriculture and manufacturing) and hence precipitating their collapse. The shift into the non-tradable sector accelerates domestic inflation, which is responsible for the rise in the real exchange rate.

These short-term macro-adjustment problems result in long-term effects on growth by reducing the country's economic diversity and increasing its reliance on exports from its natural resource sector. Equatorial Guinea—one of Africa's newest oil producers—is illustrative of how fast Dutch Disease effects can transform the domestic economy: cocoa and coffee have declined from approximately 60 percent of GDP in 1991 to less than 9 percent of GDP in 2001.²⁴

The decline of the manufacturing sector also retards economic growth by decreasing both the demand for and supply of skilled labor, which in turn, affects the level of income inequality and educational opportunities.²⁵

A number of recent studies have found, for example, that school enrollment at all levels and public expenditures on education relative to national income are inversely related to natural resource abundance.²⁶

The phenomenon of Dutch Disease, however, is not the only mechanism whereby economic growth is negatively affected by windfalls. Perhaps equally important are the incentives that windfalls create for unproductive investments, rent-seeking, and corruption.

First, the export boom exerts pressure on governments to share increased revenues with the public, often by investing in unproductive public work projects that are motivated by politics rather than profit (that is, “white elephants”) or subsidizing food, fuel, failing industries and even government jobs.²⁷

There is no shortage of prominent examples, such as the Ajaokuta steel mill that Nigeria built in the 1970s to appease the Yoruba region, which “has absorbed over US$3 billion,”²⁸ and yet, “has still not produced a commercial ton of steel.”²⁹ In addition to squandering the proceeds from their most precious commodities on failed investment programs, countries also suffer from spiraling inflation, the collapse of private savings and investment, and economic stagnation.³⁰

Second, many argue that because windfall rents are concentrated and easily obtained, they exert pressure to engage in rent-seeking and corruption—both of which harm economic growth.³¹

Windfalls can shift the focus to competition over rents, leading to a “feeding frenzy”³² and thereby distract both individuals and governments from long-term developmental goals.³³ For example, in the late 1960s and early 1970s Indonesia's state oil company, Pertamina, accrued large windfalls that generated rent-seeking opportunities for actors closely tied to the state; these mineral rents became a source of patronage for the Indonesian military.³⁴ The long-term effects on Indonesia's economy are evident in the lack of foreign investment in new energy projects over the last decade and its unique distinction of becoming OPEC's first member to import oil in 2004.³⁵

Volatility and economic growth

Another chief concern is the effect that the extreme volatility of commodities, also known as “boom and bust” cycles, can have on economic growth. Although market volatility is a problem for all exporters of primary commodities, it especially plagues oil exporters because the economic importance of oil makes this particular commodity both a valuable and an attractive political weapon.

The economic impact includes, first and foremost, unpredictable revenue streams because widely fluctuating export revenues lead to fluctuating levels in overall government revenues.³⁶

These “frequent upward or downward adjustments of fiscal expenditures are costly” because they simultaneously discourage private investment and wreak havoc on the government's budget, thereby impeding its ability to sustain investment and public goods provision.³⁷ Moreover, once expenditures become entrenched, it is harder for governments to make budget cuts; rather than reversing their spending patterns during busts, they often opt to borrow, and hence, incur huge debt burdens.³⁸

Excessive borrowing also occurs during booms. Many countries have followed the ill-advised strategy of “borrow[ing] on the strength of their booms.”³⁹

For example, although it experienced “only a small oil windfall in 1979–81,” Mexico “borrowed abroad against future oil earnings to boost expenditures by a further 1.8 percent of non-oil GDP.”⁴⁰ In fact, oil exporters “built up more debt during the 1970s”—that is, as oil revenues were rising the fastest.⁴¹

Political consequences of reliance on external rents

The main political consequences of relying on external rents⁴²

are weakly institutionalized states and skewed state-societal relations. Relying on an external source of revenue fosters weakly institutionalized states because the ease of financing state expenditures provides no incentives for government officials to build strong institutions. More specifically, countries rich in minerals, particularly petroleum, fail to develop a robust central bureaucracy because their ability to rely on an external revenue source engenders rigid and myopic decision making.⁴³ This includes, most importantly, the failure to build a viable tax regime because rulers do not feel compelled to extract revenue from domestic sources to fill their coffers.⁴⁴

In short, mineral-rich states inevitably become rentier states. Rentier states seek to exert social and political control over their populations by creating and maintaining economic dependencies through their sole authority to allocate and redistribute income obtained from natural resource rents.⁴⁵

This has three critical implications for state-societal relations.

First, the freedom to rely on external rather than internal sources of income both enfeebles the state and impairs the development of societal opposition because it reduces both the need for leaders to be accountable to the public and popular demands for representation.⁴⁶

Indeed, the lack of a viable tax regime has been consistently identified with not only impeding broad economic growth but also undermining state capacity and democratization.⁴⁷

Second, rentier states bolster their autonomy from societal forces by exploiting their fiscal independence to engage in discretionary spending. Large sums of money are spent on sustaining patronage networks and/or providing huge subsidies to the population to garner social and political support, rather than on developing institutionalized mechanisms of responsiveness.⁴⁸

The Kuwaiti government, for example, employed 75 percent of the workforce in 1975, but most were “underqualified and underutilized.”⁴⁹ In short, these states are characterized by the “progressive substitution of public spending for statecraft.”⁵⁰

Third, rentier states are subject to state capture and high levels of corruption. While the majority of the population is effectively disenfranchised, those who run the natural resource sector are able to exert disproportionate influence over government policies. There are primarily two reasons for this. First, the highly concentrated nature of the mineral sector enables the small number of firms that occupy it to form a united front to pressure the state. Second, the sheer economic impact of the mineral sector fosters a tendency for the state to conflate this sector's interest with its own.⁵¹

The Gulf States, where the oil sector and the ruling families are nearly indistinguishable, represent the most extreme illustration.⁵² As a result, both sides have a vested interest in nontransparent transactions, thereby ensuring state autonomy vis-à-vis the broader population and enabling those with access to mineral rents (first and foremost, government officials) to enrich themselves at society's expense.⁵³

The cumulative impact of external rent reliance, therefore, is not just weakly institutionalized states and skewed state-societal relations but also corrupt, authoritarian regimes. With unfettered access to huge rents, incumbents have such a disproportionate advantage over their opponents so that they can remain in office almost indefinitely.⁵⁴

These regimes also sustain themselves by simultaneously creating a strong deterrent to popular mobilization—either because they successfully preempt social discontent with populist policies or because they possess effective internal security forces.⁵⁵ The result is that only very few developing countries, such as the Republic of Congo and Venezuela, have been able to channel their oil wealth into creating the socioeconomic and political conditions conducive to democratic transition.⁵⁶

Boom and bust cycles also play a role by aggravating the effects of external rents reliance. Booms exacerbate both state spending and rent-seeking behavior, thus reinforcing the dynamic of weakly institutionalized states and corrupt, authoritarian regimes.⁵⁷

They also further enfeeble the state by actually creating a disincentive for state leaders to build strong institutions that might interfere with their ability to allocate rents to supporters.⁵⁸ Weakly institutionalized states, in turn, are unable to respond to busts, either because their bureaucracies are too centralized and bloated to adjust, sectoral interests have captured the policy-making process, or some combination.⁵⁹

Fiscal and monetary policy

From the moment that the windfalls begin, the negative economic effects associated with Dutch Disease are imminent.⁶⁰

As a first step to counter the appreciation of the real exchange rate, resource-rich states are urged to accumulate income-producing foreign assets in order to sterilize the local economy from the inflow generated by the mineral sector.⁶¹ The accumulation of budget surpluses and avoidance of large-scale foreign debt enables mineral-rich countries to smooth out expenditures during boom periods and prevent borrowing during cycles of busts. Combined, these policies help to insulate the domestic economy from the volatility of commodity revenues and generate budget stability.

Botswana is a prominent example of just how successfully countries that implement sound macroeconomic policies and spend their windfalls wisely can combat the Dutch Disease.⁶²

It has managed its exchange rate policy through the accumulation of foreign reserves and has run budget surpluses that were set aside for stability spending during periods of busts. Owing to its commitment to fiscal discipline, Botswana has shunned wasteful spending during boom periods and borrowing during busts. These policies have contributed to Botswana's rapidly growing GDP, which has enabled it to move from the 25th poorest country in 1966 to an upper-middle income country within 30 years.⁶³

So, why have so few countries followed Botswana's example? The predominant explanation is that an insulated and autonomous technocracy committed to long-term developmental goals is necessary for pushing through macroeconomic policies that may be socially and politically unpopular.⁶⁴

Yet, this overlooks the institutional capacity that carrying out and sustaining such polices requires—in particular, institutionalized mechanisms for accountability and transparency that can curb rent-seeking and corruption. More importantly, the sole reliance upon an autonomous technocracy overlooks the need for strong budgetary institutions and procedures that can constrain legislatures and ministries from expanding the budget and promoting “pet projects.”⁶⁵ Botswana was able to maintain a firm budget and prevent overspending because of a legislative procedure requiring parliamentary approval for any new public project after its National Development Plan was passed, thus preventing the executive branch from altering the budget.⁶⁶

Economic diversification

To prevent the booming export sector and the non-traded goods sector (that is, retail trade, services, and construction) from crowding out the non-booming export sectors, mineral-rich countries have long been advised to invest windfalls in economic diversification.⁶⁷

Thus, they will be able to shield their economies from shocks caused by market volatility. Economic diversification is also directly linked to sound fiscal and monetary policies—that is, when the local currency is not allowed to appreciate, the chance of decline in the non-booming sectors is reduced.

This is one of the rare areas in which policy prescriptions have been widely followed. With the endorsement of developmental economists and international organizations, such as the United Nations Conference on Trade and Development, the United Nations Economic Commission, and the World Bank, from the 1960s until the early 1980s most mineral-rich states made considerable investments in promoting other economic sectors.⁶⁸

Efforts to mitigate the effects of Dutch Disease by transferring rents from the mineral sector to the non-booming export sectors, however, have actually had a decisively adverse economic effect.⁶⁹

State-led investment in that historical context has led not only to inefficient investment but also to the perpetuation of import substitution industrialization and protectionism—both of which have independently contributed to stagnant growth rates.⁷⁰ Moreover, few countries have actually managed to diversify their economies.⁷¹ Tunisia is the only mineral economy in 1970 that was no longer ranked as a mineral economy in 1991.⁷² Thus, ironically, “the growth collapses of the late 1970s and the early 1980s resulted in the backfiring of the resource abundant countries' efforts to reduce their commodity dependence.”⁷³

These policies have failed to decrease dependence on natural resource exports for the same reason that the majority of mineral-rich states have not implemented sound fiscal and monetary policies. Because these countries lack strong state institutions and a transparent decision-making process, they are prone to making poor investment decisions—that is, decisions that are based on either shaky economic ground or political priorities, and hence, do not offer high domestic rates of return. Thus, even for an outlier such as Indonesia, which has been widely touted for its ability to sustain a viable agricultural sector since the 1970s,⁷⁴

the lack of institutionalized mechanisms for accountability, transparency, and oversight has allowed rent-seeking and corruption to flourish.

Natural resource funds

Natural Resource Funds (NRFs) consist of stabilization or savings funds and often combine both. Stabilization funds aim to reduce the impact of commodity price volatility on the economy and, in turn, improve budget predictability by stabilizing spending patterns.⁷⁵

They reduce overspending when prices are high and borrowing when prices fall because when commodity prices are high, excess revenue is placed in the stabilization fund, but when prices are low, revenue is transferred out to make up for budgetary shortfalls. Savings funds, in contrast, are intended to ensure that a share of the wealth will exist for future generations, even after the natural resources are depleted.⁷⁶

NRFs are found in both developed and developing countries. Examples include Venezuela's Stabilization Investment Fund, the State Petroleum Fund in Norway, Iran's Foreign Currency Reserve Account, and the Oman General Reserve Fund. However, their institutional structures and success rates vary dramatically. The Alaska Permanent Fund is characterized by high levels of public involvement in the decision-making process concerning the establishment and evolution of the fund.⁷⁷

Public debate has influenced how the windfalls are spent and led to the creation of a dividend program in which each citizen of Alaska is entitled to a share of the wealth generated from oil sales. In contrast, the Kuwait Reserve Fund for Future Generations is considered extremely nontransparent since information about its holdings and expenditures is neither available to the public nor to the legislature.

The popularity of NRFs continues to grow. Several new energy producers—Azerbaijan, Kazakhstan, and Chad—have also adopted NRFs. Most recently, the World Bank and the International Monetary Fund (IMF) have proposed a Petroleum Fund model to East Timor to assist it with managing its anticipated petroleum revenues from its newly discovered offshore reserves. Yet, their applicability to developing countries is limited precisely because many lack the institutions to support NRFs.

In order for NRFs to work as designed, states must already possess strong state institutions—that is, institutions that emphasize oversight, transparency, and accountability such as a professional bureaucracy that abides by clear fiscal accounting standards and an independent judiciary that can prevent the executive from arbitrarily changing the rules. It is no coincidence that the most enduring NRFs are located in countries such as Norway, the United States, and Canada—all of which have well-developed fiscal, regulatory, and supervisory institutions and also happen to be mature democracies.⁷⁸

The empirical evidence to date also indicates that NRFs have been largely ineffective in stamping out corruption and improving transparency in countries with strong chief executives that possess sole authority over petroleum contracts and complete discretion over the operation of the NRF.⁷⁹

Venezuela's fund exemplifies the risks involved in proposing an NRF for a country—even if it is a democracy—in the absence of stringent checks on and balances against executive authority. As a result, the Venezuelan government has periodically raided the fund when strapped for cash, and frequently altered the fund's operating rules to expand presidential discretion. The weakness of Venezuela's fund does not bode well for the newly created NRFs in Azerbaijan and Kazakhstan—countries that both have strong presidencies. Already in its short history, former President Haider Aliev was personally able to channel resources from the NRF to finance refugee resettlement programs⁸⁰ and the state oil company's (SOCAR) participation in the Baku-Ceyhan oil pipeline.⁸¹ Thus, where the institutional capacities necessary to support and restrict access to NRFs are absent, they can actually be counterproductive; rather than sterilizing the budget and preventing corruption, these funds can inadvertently reinforce the concentration of power and authoritarian tendencies in mineral-rich countries.

Transparency, accountability, and public involvement

Over the last few years, international nongovernmental organizations (INGOs) and IFIs have combined forces to promote transparency, accountability, and public involvement in the management of petroleum revenues in order to address the political consequences of reliance on external rents.

The targets of INGO activity include foreign extractive firms, IFIs, Western governments, and domestic governments.⁸²

First, they have pressed IFIs such as the World Bank and IMF to use their leverage to encourage countries to provide the public with accurate information about revenues received and spent. Second, they have pushed for foreign extractive firms (for example, multinational oil companies) to publish what they pay to host governments. Third, NGOs have urged governments in mineral-rich states to disclose all their transactions with foreign extractive firms and their expenditures.⁸³ Finally, they have sought to increase opportunities for public involvement in deciding how revenues will be spent through advocating improved human rights protection and encouraging a free press.⁸⁴

Campaigns such as “Publish What You Pay”⁸⁵

are a primary example of such INGO-inspired efforts. Here, a coalition of over 200 INGOs and local nongovernmental organizations (LNGOs) are working to persuade foreign extractive firms to disclose all taxes, fees, royalties, and other payments made to the host governments in the countries where they operate. In order to monitor how these revenues are used, they are also pushing for full disclosure of compensation payments and community development funding. Their efforts have been at least partially successful. British Petroleum (BP), for example, agreed to post its production-sharing agreement with Azerbaijan on a website and make its social and environmental impact assessments available to the general public.⁸⁶ Pressure from both INGOs and LNGOs has also persuaded the World Bank to create “the Extractive Industry Review” to carry out an evaluation between 2001–2003 of its role in supporting projects in the mineral sector and their impact on poverty alleviation.⁸⁷

The biggest success to date, however, may be the Chad Revenue Management Plan. In order to encourage transparency and public oversight over the use of Chad's anticipated windfalls, the World Bank has made funding to construct a pipeline to export oil from land-locked Chad to Cameroon contingent on the government meeting certain conditions, such as adopting a revenue management plan and social and environmental safeguards. One of the unique aspects of the World Bank's program in Chad is the large role for external monitoring by both societal actors (LNGOs) and foreign actors (INGOs, the World Bank, and foreign oil companies) to ensure that Chad's oil windfalls are directed towards poverty reduction programs and not wasted on non-income earning projects.⁸⁸

Built into Chad's Revenue Management Plan are different oversight mechanisms such as the Revenue Oversight Committee, which is composed of representatives from both the government and civil society and is charged with verifying government compliance with the revenue management law. Because of international and local NGO pressure, the foreign oil companies operating in Chad have also agreed to independent scrutiny of their activities and are paying for an External Compliance Monitoring Group composed of members of civil society to monitor their adherence to an environmental management plan.⁸⁹

However, there are limitations to relying primarily on external actors to build transparency, accountability, and public oversight. Pressure from IFIs, foreign companies, and INGOs is insufficient unless first, societal actors—particularly local NGOs—are empowered by institutional safeguards, such as freedom of assembly and free speech; second, both foreign and societal actors can hold government officials accountable for their actions; and third, all of the actors involved—most importantly government officials—have a mutual interest in promoting transparency and stamping out corruption. The presence of these three conditions has fostered transparency, accountability, and public oversight in Norway, for example, where well-developed political parties, independent oversight councils, and a long-standing national parliament have monitored both government spending and oil extraction contacts. Similarly, since the late 1980s an informed public in Alaska has utilized preexisting representative institutions to demand formal oversight (that is, citizen advisory councils) of the petroleum's industry's activities.⁹⁰

Conversely, the absence of these three conditions appears to be undermining Chad's Revenue Management Plan. Thus far, there is good reason to be skeptical of both the government's commitment to this plan and the ability of IFIs to enforce it. Although Chad's president initially committed to using the first signing bonus “in the spirit of the Revenue Management Law,” the World Bank was unable to prevent him from spending a large portion of this bonus ($4.5 million, or approximately 20 percent) to purchase weapons.⁹¹

There is also good reason to doubt the foreign oil companies' commitment to the World Bank program. For example, INGOs are already highly critical of the oil companies' decision to put pipeline construction ahead of the social and environmental programs that are intended for poverty alleviation and increasing public involvement.⁹² Finally, in the absence of institutionalized mechanisms of responsiveness in Chad, LNGOs may find themselves solely targeting the foreign oil companies and the IFIs rather than engaging in a fruitful dialogue with the government over management of the petroleum industry's activities and windfall rents.

Direct distribution

Despite the tacit acknowledgement that the state is a large part of the problem, none of the most popular solutions attempt to take the mineral rents out of direct state control. The only exception is direct distribution of windfall revenues to the population, which has very recently been proposed as another way to avoid Dutch Disease effects, combat corruption, foster democratic governance, and even address the problem of weak institutions.⁹³

The premise underlying this solution is that if the population receives the benefits of its natural resource wealth directly rather than through public works projects or state subsidies, it will make better investment choices and have a greater incentive to save these windfall rents than government officials. Some argue that direct distribution will also force the public to engage politically and demand oversight and accountability institutions to monitor the flow of petroleum revenue.⁹⁴

Two forms of direct distribution have been put forth: the first is based upon the Alaska model in which the interest from the oil fund is directly distributed to the population⁹⁵ whereas the second eliminates the use of a savings and stabilization fund.⁹⁶ For countries like Nigeria and Iraq where government officials have siphoned off oil rents for personal profit and suppressed all forms of political resistance for decades, the idea of spreading the wealth among the population is especially attractive.

Yet, direct distribution schemes are not without their problems. For example, if direct access to “easy money” encourages myopic behavior on the part of government officials, there is no reason to believe that it will not induce the same spending effects on an individual—particularly one living below the poverty line. There is also the danger that transferring windfalls to individuals will reduce incentives for citizens to engage in entrepreneurship, which will further stifle the growth of small and medium private enterprises in developing countries. The case of Alaska, in which the population receives an annual dividend from oil and gas proceeds via mandatory state investments in the Alaska Permanent Fund, provides a striking illustration. The transfer of rents to households has fostered an environment in which the population is focused primarily on consumption, rather than investment.⁹⁷

It has also had such a negative impact on the development of the private sector that several state-sponsored organizations have emerged to encourage entrepreneurialism among young Alaskans.⁹⁸

Even where we might expect individuals to distribute rents most efficiently, such as rents generated from peasant cash crops, the empirical evidence to date suggests otherwise. For example, although small landholders in Kenya were able to save much of the windfalls generated from the coffee boom between 1976–79 (approximately 60 percent), government controls that favored the urban sector over the rural one prevented them from investing their savings efficiently.⁹⁹

In contrast to the aforementioned solutions, direct distribution is viewed as a way to encourage institution building in mineral-rich states, particularly fiscal institutions, because the state would no longer be either the sole or the largest recipient of natural resource rents.¹⁰⁰

It would also lack the fiscal autonomy from its population that rentier states enjoy. As a result, it would be compelled to develop a workable taxation system in order to collect revenue from its citizens. In reality, however, under existing and proposed models of direct distribution the government continues to be the largest direct beneficiary of the revenue from natural resource exports,¹⁰¹ and thus, suffers from the same disincentives for fiscal discipline. The failure of direct distribution models to specify who will be responsible for the dispersal of the proceeds to the population, and hence, how to ensure that the government does not either mismanage or appropriate the revenue, moreover, limits their efficacy—especially if the state continues to own and control the production and sale of petroleum reserves.

Alaska's experience again serves to illustrate. In Alaska, the state budget is the largest beneficiary of the proceeds from natural resources. The state is required to deposit only 25 percent of the royalties it collects from the oil sector into the Permanent Fund and the interest is divided evenly among the population.¹⁰²

Much like petroleum-rich countries in the developing world, therefore, the Alaskan government has had little incentive to develop a broad-based tax system; for example, it has neither introduced a personal income tax nor broad based sales tax. As a result, the relationship between the government and its citizens is defined solely by the “government [distributing] checks to citizens instead of citizens sending checks to government.”¹⁰³ The state government also has a chronic budget deficit because it must maintain high spending levels to satisfy constituents, who prefer to maintain the dividend program rather than use the Permanent Fund to balance the budget. In the 1980s, for example, Alaska's per capita state spending was far above the national norm and included public work projects that cost millions of dollars, yet never came to fruition.¹⁰⁴ Direct distribution, then, seems to inadvertently reinforce a rentier mentality whereby the population views the government as a source of wealth distribution and the government is unable to demand fiscal compliance.

In addition, direct distribution shares the central problem of the aforementioned solutions because it requires a degree of institutional capacity that most resource-rich countries simply do not possess. At a bare minimum, it requires a viable banking system to distribute the revenues. This is not sufficient, however, to prevent government officials from engaging in rent-seeking or to curb corruption. Thus, in order to promote its perceived benefits, direct distribution also requires the same types of strong institutions as NRFs—that is, institutions that emphasize oversight, transparency, and accountability. Perhaps this is why, thus far, it has only been tried in a developed democracy with an effective bureaucracy like the United States. Yet, its success is questionable even there.

Why ownership matters

Why should we expect state and private ownership to result in such distinct institutional outcomes? In short, because they foster a very different relationship between the main actors they generate. While both sets of actors under state ownership (that is, state elites and bureaucrats) and private ownership (that is, state elites and domestic owners) are relatively symmetrical in their ability to exert influence over the other, the boundaries between them are blurred and clear, respectively. These boundaries, in turn, promote very different incentives for institution building because they impose very different transaction and monitoring costs for the actors involved.

Under state ownership, the boundary between the main actors—state elites and bureaucrats—is blurred because there is no clearly identifiable principal.¹⁰⁸

Rather, the population as a whole is the nominal principal whose interests are ostensibly served by a multitude of agents. At the same time, because the control structure is not clearly defined and there are no objective criteria for determining managerial performance, these agents often act like principals such that administrative tasks and political goals also become blurred.¹⁰⁹ The relative power between state elites and bureaucrats is symmetrical because both have direct access to the proceeds from mineral exploitation. They also both have exclusive access to information about the income—as well as the misdeeds—of the other.

In the case of the Russian gas sector, for example, it is difficult to distinguish the management from the government. For most of the 1990s, Gazprom's president and board of directors not only controlled their own shares but also were entrusted with the government's shares. Thus, they openly ran the company as if they owned it. Then, as now, the Gazprom CEO is a presidential appointee and Gazprom's managers and government representatives form a majority on the board of directors. As a result, some have suggested that it has been hard to determine where “Gazprom ends and the Russian state begins.”¹¹⁰

Blurred boundaries reduce transaction and monitoring costs by making revenue readily available to multiple principals, all of whom are charged with managing this revenue but none of whom can benefit directly when it is generated efficiently. In most developing countries, for example, petroleum resources are managed through a state oil company. Bureaucrats are assigned to run the company on behalf of the state, with the understanding that the company—and most importantly, its income—ultimately falls under the jurisdiction of the state elites.¹¹¹

These bureaucrats not only have a greater opportunity to steal from the company but also a greater incentive to do so because, as de facto government employees, they are not compensated for performance. Because they have no direct claim to the residual (or profits), they also have a greater incentive to operate the company without regard for profitability.¹¹² This is reinforced by soft budget constraints—that is, continued access to state revenue, regardless of whether or not the company is profitable.

As a result, state elites and bureaucrats share incentives for building or sustaining weak institutions. Both prefer greater discretionary power, and thus, institutions that are unlikely to constrain their behavior in any meaningful or predictable way. Neither side has an incentive to support the development of institutions that foster internal and external oversight mechanisms, increase transparency, or impose hard budget constraints. Rather, because both sides have direct access to the proceeds from the exploitation of the energy sector, they prefer greater discretionary power and informal agreements over the allocation and use of these proceeds. This encourages a form of implicit bargaining whereby each side tacitly agrees to either undermine existing institutions that might pose a threat to their discretionary authority, for example, by increasing transparency and accountability, or to maintain the status quo, and thus neglect institution building altogether. These tendencies are likely to be exacerbated, moreover, by an exogenous shock or economic crisis because time horizons shorten and opportunities for rent-seeking expand.

The blurred boundary between the state and Gazprom, for example, has benefited both sides. On the one hand, it has empowered the gas sector to operate with very little internal or external scrutiny over its transactions. For example, during most of the 1990s, the Russian Audit Chamber did not demand an official audit of Gazprom's finances. This lack of oversight is evident in Gazprom's notorious mismanagement of investment funds and arbitrary transfer of assets to board members and relatives during Boris Yeltsin's presidency.¹¹³

Gazprom's integrated structure also provides the company with a relatively costless and effortless way of hiding its profits, and thus lining its managers' pockets.

On the other hand, this blurred boundary has enabled the Russian government to utilize its leverage as the ultimate owner to fulfill its domestic fiscal and spending requirements. Gazprom remains subjected to price controls and delivery requirements for nonpaying domestic customers, which account for a large portion of its implicit tax burden. As a result, Gazprom is forced to sell most of the gas it produces (70 percent) on the domestic market for approximately 15 percent of the price it would receive on the global market. Combined with the high rate of tariff arrears in Russia among industrial and household consumers alike, therefore, it is not surprising that Gazprom operates at a loss.¹¹⁴

Nonetheless, the government has refused to lower Gazprom's explicit tax burden, contributing further to its well-earned position as Russia's largest taxpayer.¹¹⁵ Gazprom's explicit tax burden has actually increased following the August 1998 financial crisis and the adoption of a new tax code in 2000–2001. Meanwhile, its implicit tax burden has also steadily increased as government officials utilize Gazprom's budget for social and political goals such as financing election campaigns.¹¹⁶

Yet, the long-term costs of weak fiscal, regulatory, and supervisory institutions outweigh the short-term benefits to each side. In sum, the blurred boundary has created and reinforced an informal agreement whereby Gazprom's managers accept a high tax burden in exchange for the ability to line their own pockets and the government accepts less transparency and accountability for virtually unlimited access to Gazprom's coffers. This has resulted in a net economic loss for both Gazprom as a company and the Russian economy as a whole. “Years of asset stripping and lack of transparency,” for example, are responsible for Gazprom's gross undercapitalization.¹¹⁷

Under private domestic ownership, in contrast, the boundary between the main actors—state elites and domestic owners—is clear because there is a clearly identifiable principle. Because the control structure is clearly defined and there are objective criteria for evaluating managerial performance, agents do not conflate administrative tasks with political goals. Rather, they are punished and rewarded based on their ability, for example, to maximize efficiency, increase profits and market capitalization, and expand market share. Their relative power is symmetrical because each has an independent source of authority over the other. Domestic owners possess the rights to revenue from mineral exploitation, and thus, are a critical source of tax revenue for the state. State elites possess the authority to revoke property rights and reduce revenue streams through demanding excessive taxation. In short, they need each other not just to survive, but also to thrive.

Clear boundaries increase transaction and monitoring costs by simultaneously making it more difficult for state elites to extract revenue and for private owners to hide their income. During Yeltsin's presidency (1991–98), for example, the government was forced to either confiscate revenue from the oil companies or to engage in continuous bargaining over revenue burdens.¹¹⁸

Also during this period, the Russian oil companies (hereafter, ROCs) devised several legal and semi-legal schemes to reduce their profitability on paper that eventually proved too costly—not only because it required expending effort and finances on nonproductive activities but also because it earned them a lower stock market valuation.¹¹⁹

Clear boundaries also make it less rational to steal. Unlike state companies, in private companies managers are compensated based on performance and the owners have a direct claim to profits, and thus, both owners and managers are primarily concerned with profitability. Owners—including shareholders with a minority stake (that is, 25 percent of the shares)¹²⁰

—also have a vested interest in ensuring that both their managers and employees do not steal or otherwise jeopardize the company's financial health. When these minority shareholders are multinational corporations (MNCs), moreover, they can also provide further defense against state predation because they carry the added weight of access to capital, international arbitration, and foreign governments to both deter and challenge such practices.

Nor can private companies necessarily rely on the state to bail them out if they are operating at a loss. Hard budget constraints and the fear of bankruptcy thus reinforce the desire of owners and managers to run the company efficiently. As a result, they are unlikely to invest in unproductive public work projects or provide subsidies—tasks that a government often demands of state-owned companies to promote its own social and political objectives.

High transaction and monitoring costs, therefore, promote mutual incentives for building stable, effective, and far-reaching institutions—that is, strong institutions. Both state elites and private actors, for example, prefer a tax regime that is stable, so as to ensure fiscal predictability, and one that is broad-based, so as to decrease the state's fiscal reliance on the mineral sector. Both also prefer regulatory institutions that will effectively monitor companies' profits and employees. The main actors' interests concerning institution building thus converge. Yet, their preferences over the exact content of these institutions (for example, tax rates, number of audits, and so forth) will vary based on their specific interests. Combined with the fact that their relative power is symmetrical (that is, neither can impose their preferred outcome on the other), this variation in preferences over content encourages these two sets of actors to engage in explicit bargaining to formulate strong institutions. The mutual desire for formal guarantees is likely to be reinforced, moreover, by an exogenous shock or economic crisis because both actors will feel vulnerable and their continued survival will depend more acutely on the actions of the other.

The mutual desire for fiscal predictability following the August 1998 financial crisis, for example, provided the impetus for the Russian government and private domestic oil companies to negotiate a broad-based tax code that was enacted between 1999–2002.¹²¹

By most accounts, this new tax code exceeds Western standards—not only because it sets lower tax rates than the OECD recommends but also because it is much simpler and clearer than the previous one. Most important, the new tax code has resulted in an increase in the contribution of the personal income tax to the budget.¹²² Foreign and domestic financial and political analysts alike have also praised the new tax code for the inclusive nature of tax benefits, and thus, its potentially positive impact on the Russian economy as a whole. The increased tax collection rates since the new code was put into effect support this optimism. In 2004 alone, for example, Russia's federal budget recorded a 17.7 percent increase in tax revenue.¹²³

The financial crisis also motivated the ROCs to alter significantly their prior behavior and to design forward-looking development strategies.¹²⁴

Whereas governments across mineral-rich countries in which the oil sector is under state ownership commonly respond to economic crises linked to sharp declines in the market price of petroleum (or commodity “busts”) by increasing production to make up for budgetary shortfalls, thereby lowering their profits, and/or by borrowing against future expected revenues,¹²⁵ the ROCs did neither. Nor did they pool their lobbying efforts or resources to seek state protection or “capture” the policy process, as Michael Shafer¹²⁶ and others would have predicted.¹²⁷ Rather, the ROCs consciously and successfully adjusted to the current bust and prepared for future booms by concentrating their efforts on cleaning up their internal operations so as to get their finances in order and finding ways to increase both production and profits over the long-term.

A central component of this adjustment strategy consisted of building foreign partnerships through attracting minority shareholders from abroad and/or bringing in foreign management.¹²⁸

This has had several undeniably positive effects on the development of the Russian oil industry. First, the ROCs' desire to attract foreign capital, and consequently to increase share prices, bolstered their commitment to greater transparency and corporate governance. Indeed, hiring foreign managers was a conscious attempt to signal this commitment to shareholders, as well as the Russian government.¹²⁹ Second, bringing foreign expertise and capital directly into their respective enterprises enabled the ROCs to invest in new technology to increase production by tapping into old (brown) wells—a strategy that was both technologically impossible and highly unpopular among neftyaniki (oilmen) during the late Soviet period. Several of the ROC representatives and foreign investors we interviewed commented that Soviet-trained oilmen viewed this practice as “unmanly,” preferring to open up new wells when oil did not easily flow from existing ones. Some of the ROCs also viewed foreign expertise and capital as a means to realize their ambitions to build new pipelines that would open up new markets—especially China—and provide an alternative to government-controlled pipelines as a prelude to investment in exploring and developing new wells. Finally, many ROCs deliberately sought foreign partnerships in order to simultaneously expand their operations at home—in particular to the Northern Territories where exploration requires both more capital and advanced technology—and abroad so as to reduce their future dependence on domestic reserves. By 2001, for example, Lukoil had already teamed up with Conoco International to explore oil in Russia's Timan-Pechora region¹³⁰ and had approximately 40 percent of its operations in foreign markets.¹³¹

Thus while some Western analysts have criticized the ROCs failure to invest in exploration, and hence, the development of new oil wells,¹³²

these efforts suggest a different picture. Combined, they indicate a strategy that is aimed not only at long-term investment but also at securing multiple sources of oil and access to new markets. On the one hand, these analysts and others have downplayed the ROCs attempts to explore new fields in the Far East, for which present production-sharing agreement (PSA) legislation privileges foreign investors.¹³³ On the other, they have overlooked the fact that the ROCs eventually want to be able to compete on the same playing field as other multinational oil companies, which requires looking beyond domestic production and existing markets.