Building on a strong primary sector as the basis for structural transformation

In brief… Although promising in the long run, and feasible strategy options for some of Africa’s middle-income countries, high-skill services and advanced manufacturing offer limited opportunities for accelerating structural transformation in the near term for most of Africa’s low-income countries. The importance of learning processes, capabilities and factor endowments suggests that building a strong primary sector can be the fastest way to structural transformation. The primary sector can drive structural transformation through four channels: i) linkages and diversification into adjacent activities; ii) as source of employment for large numbers of low-skilled workers and consequently also the source of demand for potential new products from new activities; iii) as source of government revenue, mainly from extractive industries, but industrial agriculture can be important too, which can then be invested in creating the right conditions and pushing structural transformation; and iv) attracting foreign investment that brings capital and know-how. Foreign investment also serves as an indicator as to which sectors and activities have potential. Trade data show that a diversified primary sector is closely related to a diversified manufacturing sector. Common capabilities and good framework conditions are the links. The primary sector needs the right environment: most requirements are similar to those of manufacturing. In addition, activities based on natural resources have special requirements on which governments should focus, such as transport links to rural sectors, energy for mining, regulations that set the right incentives and a strong system of land management. Where these are not in place, only resources with very high rents can be exploited profitably. Yet these offer fewer opportunities for structural transformation.

To accelerate structural change new activities must meet four criteria: provide large-scale employment for unskilled workers, be of higher productivity than existing activities, be subject to pressure to perform and be sufficiently close to a country’s comparative advantage and capabilities. First, they must provide employment for a large number of people with no or few skills that work in low productivity activities today. Although important improvements have been made and educational attainment in Africa is on an upward trend, educational attainment in most of Africa is low relative to other regions. Second, new activities must be of higher productivity than existing activities or at least exhibit the potential for it. To propel structural transformation, expanding existing low productivity activities is not enough. Third, new activities must be subject to pressure to perform. Competition creates such pressure. In a few countries capable governments have created such pressure without competition, but many have failed. Without the pressure to perform new activities are likely to become inefficient and ultimately cause negative structural change. Finally, new activities should be in line with existing comparative advantage, or at least not too far away from it. A country’s comparative advantage, here simply defined as the products of which a country produces relatively more, reflects the country’s endowment with production factors (land, labor, capital, natural resources) and its capabilities, which are embedded in human capital, technology, institutions and regulations, infrastructure, government capacity, and public services. The degree of spillovers and learning opportunities that new activities offer is positively related to their proximity, measured in factor intensities and capabilities, to existing activities (Hausmann et al., 2011). Activities that require a very different set of factors and capabilities from the ones present in a country 8 are unlikely to generate learning and spillovers. They are also unlikely to last. In the best case, such activities will remain islands or enclaves with very limited potential for structural transformation, in the worst case, they will waste large amounts of resources before failing entirely (see also Lin, 2012). These four criteria point to challenges and opportunities for structural transformation in Africa.

Given a large number of low-skilled workers in Africa, aiming for high-skilled services as a vehicle of structural transformation too soon may not work. It is sometimes argued that Africa might just follow the “Indian” model and direct its energies toward services. 9 This is misleading for several reasons. First and foremost, the service sector that most people have in mind when they think about India’s success is the business services sector. But many tasks in the business services sector require high levels of education, which remains a relatively scarce form of human capital in most African countries. Moreover, this sector directly employs only a very tiny fraction – around 2% – of India’s labor force. So even in India, it has not been a force for the kind of employment growth that would allow for large numbers of people to move from the agricultural sector (out of poverty) into more productive sectors and higher-paying jobs. Achieving broad-based growth on the basis of business services sectors in Africa, therefore, seems unrealistic, except, potentially, for small countries with a well-educated labor force such as Mauritius or Botswana.

Low-skilled services hold more promise, but many activities are of low productivity. Most of the low-skilled service sector in Africa is made up of informal activities in occupations such as personal services and trade. Although these activities are very important for the generation of employment they hold little promise for productivity gains with a few exceptions such as large-size retail commerce (supermarkets) and tourism. While these two areas have seen important growth rates over the last years and will continue to do so, even so, their employment potential in most countries is limited.

Manufacturing holds the potential promise of large numbers of low-skilled jobs and new capabilities. However, past productivity increases were not met with a commensurate expansion of employment. Rodrik (2011a) has shown that manufacturing industries can serve as escalator activities because they exhibit an unconditional convergence of productivity growth. 10 In other words, once a country successfully enters a specific industry the productivity levels of this industry will begin to rise towards the global technology frontier irrespective of the country itself. Manufacturing also holds the promise of “generating millions of jobs for unskilled workers, often women, who previously were employed in traditional agriculture or petty services” (Rodrik, 2011b). After all “industrialization was the driving force of rapid growth in southern Europe during the 1950s and 1960s, and in East and Southeast Asia since the 1960’s” (Rodrick, 2011b). Yet, as the preceding analysis of structural transformation has shown, the productivity increases that were realized in the manufacturing sector in Africa did not come with sufficient expansion of employment. During the 1990s the overall contribution to structural change was even negative, as labor was shed. This has improved markedly during the 2000s, but the pace of employment expansion in the manufacturing sector is still much too slow.

Jumping straight to advanced manufacturing has been fraught with difficulties in the past because the importance of existing capabilities and learning processes had been overlooked. Many African countries pursued fast industrialization between the 1960s and 1990. Although superficially these strategies seemed to build on existing factor endowments, often targeting the processing of natural resources, they were largely dominated by misconceptions about the links between natural resources and structural transformation and the importance of capabilities. In attempts to industrialize, learning processes, the complexity of technology and the importance of the general business environment and complementary inputs 11 were underestimated, while the potential for value-addition was often overestimated. 12 The result has been little industrialization to show for the efforts made. 13

These challenges were compounded by the lack of pressure to perform, creating unsustainable structures that required subsequent painful reforms. The end of this unwinding was an important factor behind the recent turnaround in structural change in Africa. Not only did industrialization not come about: worse, the large public sectors and high levels of protection for inefficient sectors built up during the early push for industrialization proved to be economically and socially unsustainable, leading to a decade-long process of structural adjustment that started in the mid-1980s. This period of structural adjustment was marked by a significant decline in the share of the labor force employed in the formal sector and a movement of labor out of the industry and back to agriculture. In other words, unwinding the results of misguided attempts at industrialization in the past has been a driving factor of the negative structural change observed in Africa during the 1990s. Having largely completed this unwinding, which came at high social costs, made the turnaround towards positive structural change possible.

For structural transformation to take off, Africa needs to focus on creating capabilities. Entrepreneurs need the right environment to thrive in. Despite past failures, Rodrik’s finding of unconditional productivity convergence in manufacturing points to the potential of this sector for structural transformation (Rodrik, 2011a). To combine productivity increases with job creation, the firms active in this sector need an environment that allows them to expand their activities and invites other entrepreneurs to join the sector with innovations, expanding employment. An economy’s ability to competitively produce and export new products depends on its capabilities. Capabilities are best understood as a mix of specific technological know-how and skills with environmental factors such as the quality of public services (infrastructure, education, health, etc.) and financial services, institutions and regulations, as well as the general level of government capacity and human capital (Hausmann et al., 2011). In addition, the size of the reachable market and macroeconomic and political stability are important factors in the environment.

Box 6.2. Structural reforms and transformation in Zambia and Mozambique

Zambia’s first free elections in 1991 were won based on a commitment to comprehensive structural adjustment and the promise of more transparent and accountable governance (Bratton and Liatto-Katundu, 1994; and Thurlow and Wobst, 2004). After two decades of policies emphasizing state ownership and import substitution, the government inherited an unstable and contracting economy with high poverty and inequality, a collapsing copper-dominated export sector, and massive foreign debt. The fourth structural adjustment program (SAP), which began immediately after the new government was elected, encompassed: i) macroeconomic stabilization; ii) public sector reform; iii) external liberalization; iv) the privatization of state assets, and v) agricultural reforms. Although these reforms hoped to stimulate growth and diversify the economy, GDP growth remained stagnant at 0.2% throughout the 1990s.”

They go on to show that this period of structural adjustment was marked by a significant decline in the share of the labor force employed in the formal sector and a movement of labor out of the industry and back to agriculture. They show that much of this was precipitated by the privatization of state-owned factories. Finally, they show that between 1999 and 2001 things were beginning to turn around in Zambia. They attribute the turnaround to a more stable macroeconomic and political environment in which the government was able to mitigate the effects of Zambia’s copper exports on the exchange rate and domestic prices.

The story in Mozambique is not very different. After a prolonged period of civil war, Mozambique entered its first structural adjustment program with the World Bank in 1987 (McMillan, Welch and Rodrik, 2003) The first period of reform lasted until 1990. A second, more aggressive period of reform began in the early 1990s. Among the casualties of this reform were state-owned enterprises. For example, by the end of 1994, all the formerly state-owned cashew-processing factories had been privatized, releasing thousands of workers who typically returned to agriculture because little else was available. It is only in recent years that the cashew-processing sector in Mozambique has been beginning to hire new workers. However, the scale of the sector is still much smaller than it was under state ownership.

Currently, African firms are held back by the environment they face. Small market size, poor public services, and financial access, and the role of government are the main obstacles, translating into higher external costs. The negative effects of institutions and the business environment at large on the growth and performance of companies in manufacturing in Africa are well documented. 14 Controlling for the business environment, African firms actually have higher productivity and sales growth than firms in comparable countries in other regions. However, given the existing environment, African firms trail those in other regions. The biggest burden on the growth of African firms is geography, in the form of small market size. It pulls down the GDP of African firms by almost 100% compared to non-African firms. The other fundamental explanations for African disadvantages are associated with the basic market-supporting roles of the government: property rights protection, infrastructure, and access to finance. Interestingly, party monopoly seems to account for 81% of the total factor productivity disadvantage of African firms compared to non-African firms (Harrison, Lin, and Xu, 2013). 15 Gelb, Ramachandran, and Turner (2007) show that external “costs (electricity, transport, communications, security, rent, business services, and bribes) form a larger share of the costs of firms in African countries than elsewhere.” In Kenya, for example, the average gross (at factory level) total factor productivity (TFP) is about 70% that of China. Kenya’s net (in the international market) TFP, however, is only about 40% that of China (Eifert, Gelb and Ramachandran, 2005; see also AfDB, et al., 2012).

In addition, in African low-income countries, labor costs are higher than elsewhere, suggesting that low-wage labor is not actually a competitive advantage for Africa. African firms on average have to pay a labor premium of 80% compared with the average firm in other regions at the same level of GDP. Firms in Africa are more productive but also face a steeper labor cost curve; as firms become larger and more productive their labor costs increase more in Africa than elsewhere (Gelb, Mayer, and Ramachandran, forthcoming). Labour costs are particularly high in African firms that are productive and labour-intensive – exactly the type of firm most desirable for structural transformation. Africa’s higher labor costs could be driven by a range of factors. A high price level is likely to be an important factor. Decomposing purchasing power parity (PPP) exchange rates shows that low-income countries in Africa on average have a PPP price level that is about 20% higher than the average for the four poorest comparators. In other words for the same wage in dollars, a worker in a poor Asian country can buy more than a worker in low-income Africa.

Africa’s land abundance presents a challenge for creating a better infrastructure environment. Compared with other regions Africa is land-abundant and comparatively scarcely populated. With 36 people per square kilometer, Africa’s ratio of population to surface area is much lower than that of Europe (120 in the European Union [EU], East Asia (also 120) and South Asia (342), and more akin to that found in the Americas: Latin America counts 29 people per square kilometer and the United States 33; (World Bank, 2013b). This translates into much higher costs for some of the public services that are essential for structural transformation. Wood (2002) estimates that “Africa will need to invest at least twice as much of its GDP in infrastructure as will low-income Asia and will have higher recurrent charges for operation and maintenance.”

Africa’s factor endowments also suggest that the primary sector will continue to play a more important role and manufacturing a less important one in Africa than in Asia or Europe. The preceding paragraphs have shown that Africa is land-abundant and skill-scarce relative to other regions. Africa thus has a high land-to-skill ratio. Comparing regions over time, Wood and Mayer (2001) show that countries with high ratios of land to skills tend to export mainly primary products. As the land-skill ratio falls the export mix shifts towards simple and then more complex manufactures. Given the large gap in population density, Africa will probably never match the land-skill ratio of Asia or Europe. Its sectoral and spatial structure will converge to those in the Americas, which always relied more heavily on the primary sector, defined as agriculture and extractive industries, than on manufacturing because of land abundance, rather than to those in land-scarce Asia or Europe, where manufacturing plays a more important role (Wood, 2002).

This need not be bad news. The primary sector holds the potential for creating new activities for enhancing structural transformation that builds on existing factor endowments and capabilities. Counting agricultural commodities, timber, metals and minerals, and hydrocarbons, raw commodities and resource-based semi-processed goods account for 80% of Africa’s exports 16 (see Box 6.3 for classification of natural resources). Commodity production also accounts for 50% to 60% of employment on average, and in some countries, even 80%; most of it in agriculture as has been seen in the preceding section, but a significant amount of highly productive jobs are also in the extractive sector. Although Africa boasts a range of emerging capabilities in other sectors, especially services, the bulk of capabilities related to trade and employment are within, or closely related to, the primary sector. 17 See Hidalgo (2011) for an analysis of the East Africa product space and opportunities for diversification based on the capabilities present in the region. The primary sector offers four channels to drive structural transformation:

First, new activities and capabilities can be fostered through linkages and diversification into other natural resource activities. The most sustainable path to new capabilities that can support new activities is that of proximity to existing capabilities (Hausmann et al., 2011; Hidalgo, 2011; Neffke, Henning and Boschma, 2009; Lin, 2012). Therefore, the diversification into new activities that could have an impact on structural transformation in a relatively short period of time will have to make use of the existing capabilities in the primary sector. Two mechanisms can be used: i) linkages to and from natural resource production into adjacent activities. For example, providing supplies of goods and services for the agricultural and extractive sectors or processing local food commodities into goods with higher value-added, and ii) diversification into adjacent natural resource activities that make use of existing capabilities and geographic conditions.

Box 6.3. Africa’s spectrum of natural resources: definitions

To cover the whole spectrum of Africa’s endowment, for the purpose of this chapter natural resources are defined as comprising all commodities of agricultural, mineral and hydrocarbon origin. Following this wide definition the term “primary sector” refers to both the agriculture and extractive sectors.

Agricultural or “soft” commodities consist of food commodities and fisheries, as well as agricultural non-food products and industrial crops. Agricultural food products include fruits and vegetables, cereals such as wheat and rice, and plantation crops for the production of beverages (tea, coffee, and cocoa, for example). Livestock such as cattle, sheep or goats, and all fishery products also fall in this category. Non-food products comprise industrial crops such as timber and cotton, as well as indigenous natural products and the cut-flower industry.

Minerals and metals, or “hard commodities”, comprise precious metals and minerals such as gold, silver, platinum, and diamonds, as well as ferrous (iron) and non-ferrous base metals where copper, zinc, lead, and aluminum are the major varieties. Rare metals (cobalt, molybdenum) and minerals (phosphates, sulfates, etc.) also fall into this category.

Hydrocarbons also referred to as energy commodities, include any resources used for power production. This refers to petroleum products (namely oil and natural gas) and coal, 18 but also includes uranium and plutonium to be used as inputs for nuclear power production. 19

These three categories hint at Africa’s richness and the large variety of natural resources it boasts. The inclusion of agricultural commodities enlarges the common understanding of the term “natural resources” which is often understood as only comprising resources of mineral and hydrocarbon origin. Although separating out agricultural goods as a separate analytical entity makes analysis easier and certainly makes sense for many issues related to the high-rent nature of some of the extractive resources, it does not do justice to Africa’s natural richness. Moreover, despite their obvious differences, all three resource types have opportunities and challenges in common. For one thing, all-natural resources are derived from the earth with the input of labor and capital. Wheat is grown and copper extracted. Both need human ingenuity, labor, and capital. Second, taken together they form the basis of most product value chains. Third, prices of all three resource types have risen hugely over the last decade, almost in harmony, offering opportunities, but also dangers of inflation, volatility and the creation of dependency. Applying a wide lens of analysis, therefore, allows for more comprehensive policy conclusions.

Second, the primary sector, especially agriculture, holds the key to broad-based structural transformation as the largest employer of low-skilled labor. In fact, experience from other regions suggests that broad-based agricultural transformation is a prerequisite for industrial development (Johnston and Mellor, 1961; Henley, 2012). “This (a) provides cheap food for domestic consumption enabling a low-cost industrial labor force to survive, (b) drives up incomes of farmers, who in turn become consumers of industrial goods, and (c) frees up labor for industrial and urban jobs and savings for investments” (Gelb, Meyer, and Ramachandran, forthcoming). The development of domestic supplier networks into soft, hard and energy resources is another opportunity for job creation, which has relatively low thresholds in terms of technology and scale.

Third, the primary sector, particularly extractive industries, can create important revenues for the state to invest in structural transformation. The investment needs for structural transformation in most African countries are huge. Infrastructure and education gaps top the list in most countries. Yet each country faces specific bottlenecks that must be addressed to accelerate structural transformation. Extractive industries offer revenue potential that can be used to address these bottlenecks with targeted investments. Framework conditions for both enhanced structural transformation and the development of dynamic resource sectors can thereby be improved.

Fourth, a strong natural resource sector can attract foreign investment, which brings otherwise scarce capital and know-how. Foreign investment also serves as an important indicator as to which sectors offer potential. With roughly 60%, natural resources continue to attract the majority of greenfield foreign direct investment (fDi markets, 2013). For many low-income countries in Africa foreign investment related to natural resources is an essential source of capital. It also comes with important know-how. By interacting with foreign investors, resource-producing countries can gain valuable knowledge about the industry and requiring foreign investors to transfer technology can enable the development of local capabilities. FDI can also serve as an important indicator for evaluating the competitive potential a specific sector has to offer. Getting this assessment wrong was one of the reasons for the failure of industrial policies in the past. Instead, governments should focus on attracting FDI and invest in those areas where such investments are forthcoming. In this respect, the recent uptake in greenfield FDI in Africa in resource processing and energy generation, driven largely by projects of petroleum refineries, liquefied gas, and fossil fuel electricity generation, is very encouraging. 20

Investments in exploration and exploitation are a good indicator of the strength of a country’s resource economy and the quality of the business environment. Having great resource potential does not guarantee that this will be exploited. Gold in the sea is a good example. It is assumed that the world’s oceans contain billions of tonnes of gold. But this is not being exploited because no viable technology exists. Technology is one factor, economic incentives another: Egypt boasts plentiful oil and gas reserves but is unable to cover its domestic demand because the sector regulations in place deter further foreign investment in exploitation.

Analysis of relative comparative advantage demonstrates the close link between a strong resource sector and a strong manufacturing sector. Balassa (1986) defined a country’s revealed comparative advantage (RCA) as the number of products of which the country exports relatively more than the average. When this concept is applied separately to raw commodities and products with higher value-added it can be seen that the RCAs of countries in both categories are closely related. Countries that have comparative advantages in a large range of raw commodities also tend to have comparative advantages in a wide range of higher value-added products (Figure 6.5 and Figure 6.6). Thus, instead of holding a country back, a strong and diversified primary sector is an important step towards a diversified economy that creates productive jobs.

However, a geological abundance of resources does not automatically translate into a strong primary sector. Africa’s natural resource exports are less diversified than those of other regions. Despite the heavy concentration of raw commodities in African exports, the range of such commodities in which Africa has a comparative advantage is limited compared to other regions (Figure 6.7). Only 13 African countries export more commodities with RCA than the global average. South Africa is far ahead with RCA in 46 commodity products, followed by Morocco (36) and Tanzania (34).

To drive structural transformation, natural-resource sectors need the right conditions. Much of what is holding back structural transformation into manufacturing also stands in the way of stronger natural-resource sectors. While the geological distribution of resources such as land, mineral and hydrocarbon deposits is given by nature, resource abundance in economic terms is largely determined by the conditions for exploration and exploitation faced by investors and farmers. The preceding section has shown that governance, measured by the Mo Ibrahim index, and primary school completion are closely related to positive structural transformation. The same holds for the performance of the hard and soft resource sectors. Figure 6.8 shows the relationship between a country’s gross per capita production of hard and soft resources and the Mo Ibrahim index. 21 Similarly, public services in the form of infrastructure, land management and a reasonable level of property rights are as important for natural-resource production as for other sectors of the economy.

In addition, agriculture and extractive industries have specific requirements that must be met for the unleashing of their potential for structural transformation. The provision of the right skills, transport and energy infrastructure, land management, and sector-specific regulations stand out. One of the biggest obstacles to the transformation of agriculture in Africa has been the dearth of research and skill-building that could have brought about productivity increases as has been the case in countries that experienced “green revolutions”. The same holds for the extractive sectors. Although international investors can bring in qualified personnel from abroad, African countries are missing out on the opportunities to create new capabilities offered by these sectors because the domestic skill base is insufficiently tailored to the sectors’ requirements (see also Box 6.4). In terms of infrastructure mining often needs huge amounts of energy that far surpass what is available and are needed by other sectors; agriculture needs more efficient transport links from rural areas to urban centers. Given the land-intensity of natural-resource production, efficient land management is crucial for success and among the primary obstacles to this sector in Africa. Finally, sector-specific regulations such as the rules governing ownership, exploration and exploitation concessions and licenses and resource-specific taxes are evidently very important.

Box 6.4. Investments in human capital and applied research and development play a crucial role in the resource sectors and structural transformation

The takeover by the United States of world leadership in manufacturing was propelled by the research and education institutions originally established to serve the mining industry. The developments in the mining sector were accompanied by a continuous process of research and learning, which generated technological progress, brought down costs and resulted in the expansion, rather than the depletion of natural resource stocks. The United States Geological Survey (USGS), a large-scale governmental science project, for example, provided detailed maps of great practical value to miners, as it was highly responsive to their needs. The provision of engineers from schools designed to train mining specialists, such as the Columbia School of Mines, promoted the expansion of the sector further. These mining schools, which later evolved into the University of California at Berkeley and Stanford, among others, became the basis for technology-driven development in many industries thereafter and thereby laid the foundations for structural transformation (Wright and Czelusta, 2004).

In Sweden, structural transformation based on the resource sectors was driven by government interventions targeting research and education. The focus of universities was shifted towards natural sciences. Newly founded technical institutions soon became a source of innovation. Vocational training institutions assured the dissemination of knowledge and supply of qualified technical personnel. Moreover, study trips and training of Swedish engineers abroad facilitated technology transfer. Later on, the long-term focus on technological upgrading and exchange also paved the way for the emergence of the telecommunications sector. Sweden’s knowledge clusters originating from the forestry sector were well equipped to react rapidly to technological breakthroughs which drove the expansion of telecommunications and information technology (IT) (Blomström and Kokko, 2007).

Applied research to promote productivity plays a major role in structural transformation. In Indonesia, the availability of new rice varieties was instrumental in boosting productivity in the agricultural sector, a major driver of domestic demand (Gelb and Grasmann, 2010).

Where natural resources find a favorable environment initial dependence can quickly be overcome, even as the natural-resource sectors keep growing. Figure 6.9 illustrates the historical paths of countries that turned natural-resource wealth into structural transformation and long-term growth. Their experiences suggest that, at low levels of development, resource commodities, whether soft or hard, are the main income earners and account for large shares of exports and GDP. In other words, the economy’s dependence on resources is high. This is to be expected, as resources are comparatively easy to produce and export. In a small or underdeveloped economy, the resource sector will, therefore, account for most exports and a significant share of GDP. As investment pours in, production expands quickly and often further reserves are proven. Both abundance and dependence increase. As the resource sector expands it creates opportunities for the rest of the economy: resource production requires a large range of supplies, from food for its workers to higher technology activities such as software design, chemical analysis and customization of machinery. At the same time, resource exports generate important revenues for the state that can be invested in human capital (education and health) and public capital (infrastructure and public services) thereby creating opportunities for economic activities that are relatively intensive in these types of capital. The original comparative advantage in natural resources can thus be used to push the production possibility frontier outwards and create new comparative advantages through diversification. If the country manages to use its resource endowment in this way, over time resources will become less important as the rest of the economy becomes larger. 22 During this process resource production and the number of proven assets are even likely to continue growing, as new technology and an improving regulatory framework lead to new discoveries, but resources will lose in importance relative to the rest of the economy. In the case of hard and energy resources, abundance will finally decrease as the existing reserves are depleted or become unviable for economic (relative price of labor and capital), social (harm is done to neighboring communities) or environmental (environmental damage of extraction, climate change) reasons. This need not be the case for soft resources which do not face depletion as long as they are not exploited beyond their rate of regeneration. 24 Using data on natural resource rents as a percentage of GDP for resource dependence and subsoil assets per capita for resource abundance, Figure 6.10 shows this trend holds globally and the world continues to be on the upward sloping section of the abundance curve.

Note: Country income groups only include countries with subsoil assets and exclude high-income non-OECD countries. Resource abundance is measured as subsoil assets per capita, resource dependence is rented as % of GDP.

Where the conditions faced by the primary sector are poor and support is absent, however, structural transformation is inhibited because the resource types that offer most opportunities cannot develop. The high costs that result from poor conditions are the main factor. 25 The higher the costs faced by natural-resource producers, the higher the resource rent must be to allow for profitable exploitation. Yet it is the natural resources with lower rents, especially agriculture and base metals, that offer most opportunities for structural transformation through linkages and employment. Where these resources cannot be profitably exploited they remain either dormant, as in the case of many unexplored metal and mineral deposits (see the section on “The primary sector in Africa past and present”), or at subsistence level as in the case of most African agriculture and artisanal mining. Yet a subsistence economy is insufficient for structural transformation as it creates no demand for new products and no surplus savings to invest in new activities. In such a situation the majority of workers remain stuck in low-productivity activities based on natural resources with few ways out.

High-rent resources, on the other hand, can thrive in any environment, but offer much less in terms of linkages and employment and instead can quickly lead to dependence and therefore need strong management. High-rent resources, such as oil and to a lesser extent also gas and some deposits of precious metals and diamonds, do not require much in terms of favorable conditions. 26 If energy resources were included in Figure 6.8 the relationship between resource production and governance would disappear. This is primarily positive, as these resources enable countries to gain access to major revenues irrespective of gaps in infrastructure and government capacity. However, hydrocarbons offer fewer possibilities for diversification than other resource types and have very low values of connectivity with other products (Hidalgo, 2011). In other words, the capabilities linked to the production of oil and gas offer only very limited opportunities for learning processes that make possible successful advances into other activities. Moreover, oil and gas production is more capital intensive than mining and far more so than agriculture, offering fewer opportunities for employment and consumption multipliers. Instead, as most examples of African oil exporters show, the large rents in this sector can crowd out other sectors and create a rent-seeking economy that is incapable of overcoming dependence. Nevertheless, several countries have proved that high-rent resources can be turned into broad-based growth through strong and focused management. Botswana’s management of its diamond sector is the best example of Africa. See Box 6.5 for the examples of Malaysia and Indonesia.

Box 6.5. Indonesia and Malaysia: Two examples of turning oil dependence into structural transformation

Indonesia succeeded in controlling oil dependence through counter-cyclical spending and transformation into agriculture. The government of the Suharto period had come to power 1966 with a firm commitment to stability. Pertamina, the national oil company experienced a crisis in 1975 as a consequence of mismanagement by the military associates of the president. This failure enhanced the credibility of a more technocratic team of economic advisers with a sound understanding of the risks inherent in mineral exploitation, enabling them to implement controls on spending. So even though the government officially respected the law requiring it to balance its budget, the technocrats were able to slow spending without public disclosure. This established de facto a counter-cyclical budget and resulted in a surplus, which enabled the government to react proactively to the end of the oil price boom in 1981. The government stabilized the exchange rate by devaluation, and cut subsidies and spending. This prevented adverse effects of exchange rate appreciation on non-oil traded sectors and encouraged a wide range of exports and manufacturing. Structural change was promoted by using the country’s oil resources to increase agricultural productivity. Applying broad-based development policies, the government made possible the spread of new disease-resistant and high-yield rice varieties. Oil resources were used to develop deposits of natural gas for export and as an input to fertilizer production. The fertilizer, which was distributed to farmers at subsidized prices, increased agricultural yields significantly (Gelb and Grasmann, 2010).

Malaysia diversified its economy and emerged as a successful middle-income country based on its commodity sectors. The country, which used to be an agrarian economy up to the 1960s, used its oil, forestry sector and palm oil to drive structural transformation and growth. Even though the industrial sector had been increasingly prioritized by development policy, the agricultural and rural sector remained the focus of development policies with the objective of commercializing production (Gelb and Grasmann, 2010). This led to a steep increase in the export crop sector (mainly rubber and palm oil) both in the area of cultivated land and production between 1960 and 1990 (Rahman, 1998). Within the oil sector, the state-owned oil company Petronas played a central role in the exploitation and negotiating technology transfers from multinational firms. It thereby built up expertise and know-how and is now a Fortune 500 company that competes successfully in the international market. Even though Petronas is not publicly listed, information on its profits, dividends paid to the government and its contributions to the government budget are published and publicly discussed, which enables civil society to hold the government to account. Malaysia’s federal system and robust democracy, coupled with constituencies rooted in the non-oil sector, forced political parties to compete for solutions to the main problems facing voters. That was probably one major factor driving the reduction of poverty from 50% at independence to 3.6% in 2008 (Akitoby and Coorey, 2012). Structural transformation and diversification of Malaysia’s economy were facilitated by macroeconomic stability, high rates of saving and investment, and economic openness. Moreover, Malaysia invested heavily in energy and infrastructure and built an extensive network of highways which links it to neighboring countries, as well as advanced telecommunication systems. By 2009, exports of manufactured products represented 70% of total export value, and 45% of Malaysia’s total export value was electronics for the US and European markets (Akitoby and Coorey, 2012).