Why Resource-Rich Economies Are Really Cursed

When it comes to investing in overseas markets, beware of countries that are heavily endowed with natural resources.

Contrary to popular belief, if an economy has lots of oil, iron ore, natural gas, timber or other industrial materials, is usually an economic curse rather than a blessing.

The problems are multifaceted, but for investors it can make investing in resource-heavy economies something of a roller-coaster ride. Some examples of countries that have recently seen an economic swoon include Australia, Canada, Brazil, Russia and Saudi Arabia.

Think of them, and those like them, as the boom-and-bust economies.

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They all took a beating of some sort as commodities prices hit the skids. The Thomson Reuters/CoreCommodity CRB Commodity index, which measures the prices of materials and agricultural products, fell from 307 in July 2014 to 160 in January.

This isn't an isolated incident. The cycles will repeat.

Big currency moves. One of the biggest problems is that countries that rely heavily on exporting commodities can see massive swings in the value of their currency.

We've seen this recently in Brazil and Russia where the currencies, the real and the ruble, sank as the price of oil and gas plunged.

"When currency weakens and inflation blows out, consumer and business confidence drops, and consumption drops," says Bert van der Walt, a portfolio manager at Mirae Asset Global Investments.

Weakness in the commodity sector puts a damper on all other sectors in the economy when a country has a large natural resources sector. The falling exchange rate means rising prices for imported goods at the same time as the economy is weak.

A double whammy, if you like.

It's also damaging to a resource economy's long-term development potential when the currency rises. A soaring currency makes other industries less competitive in the world market. Higher exchange rates can make it harder to export automobiles.

Skewed economy. "When the economy is very narrowly focused on commodities, it crowds out the other sectors of the economy," says Atul Lele, chief investment officer at Deltec International Group in Nassau, Bahamas. "As an Australian, it's an issue close to my heart."

Australia benefited greatly from the commodity boom through exporting coal and iron ore to China, where it was used to make steel.

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But that boom made a problem for non-commodity companies because very quickly the resource revenues in Australia's booming mining sector pushed the costs of other things, such as wages, housing and office space up as well.

Those increased costs make it harder for the non-commodity sectors to stay competitive.

Government problems. One of the important questions for any government is deciding what to do with tax revenues. It's no less so for governments in resource-rich countries. When times are good for oil exporters the temptation can be to give the people tax cuts. It sounds great until the price of the energy crashes and the government can no longer afford to provide the services it promised.

"The differentiation between resource economies is whether the countries have made sound fiscal reform in the boom years," Lele says. "Norway is a great example."

That Nordic country, which has energy resources, pours money earned from the resource sector into a sovereign wealth fund that it then invests around the world. That's one way of saving the wealth for future generations and helping diversify away from the boom-and-bust cycle.

Another way to broaden the economy is to "engage in infrastructure programs instead of tax cuts," Lele says. Improved roads, water systems and telecommunications all help make an economy attractive when the mineral wealth withers.

Corruption. One of the sad things about countries with vast mineral wealth is that many get afflicted by corruption.

"If you are resource-rich it means that someone wants to get rich, so you open yourself up to graft," says Adam Johnson, founder and author of the Bullseye Brief newsletter. "So you have to mind the shop."

A quick look at this year's ranking of Transparency International's Corruption Perceptions Index is illuminating. As the name suggests the index ranks countries on how corrupt they are perceived to be. The higher the rank, the lower the perceived corruption, and vice versa.

"The obvious one is Venezuela," says Johnson.

In the 2015 survey, oil-rich Venezuela ranked way down the list -- 158 out of 168 countries, just ahead of war-torn Iraq.

Likewise, Brazil, Russia, and Nigeria, all blessed with large petroleum reserves, ranked 76, 119, 136, respectively.

"Brazil has been rocked by the Petrobras (ticker: PBR) scandal, in which politicians are reported to have taken kickbacks in exchange for awarding public contracts," states the Transparency International website.

For investors, the presence of endemic corruption a double problem. Corrupt countries tend to grow more slowly than less corrupt ones. Also corruption makes it hard to do business as efficiently as would be possible in a less corrupt country.

[See: 9 Ways to Harness the Growth of Latin America.]

There are, of course, some non-corrupt countries that do have abundant resource wealth such as Norway and Canada, which are ranked fifth and ninth, respectively, on TI's index.

Simon Constable is a columnist and author. In addition to following the financial markets, he likes to watch his cat play with string. You can follow him on Twitter @simonconstable.