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The Caspian Slates ind Energy Wealth: New Threats Is Growth and Stability) |

Acccarhng io CIA baseline projections derived from resource estimates and expected investment, oil production for the Caspianholerom lessillion barrels per day toillion per day. Gas production, although less certain, is projected to quiniuple fromem (billion cubic meters)ctn.

The "conventionalspoused by planners in the Caspian states and by other observers, io lhat these energy-rich newKazakhstan,apid increase Ingrowth and lhat whatever economic difficulties they now face will be overcome by energy wcallh. This positive picture rests on two assumptions: first, that these states will continue and even accelerate broad-basedreforms; second, thai energy wealth can be absorbed smoothly into the economy and will make reform easier. Based on our own econometric modeling and on extensive consultation with private-sector energy experts, we believe both jvsumptions are que>tionab.e. An "alternative view" that

we judge equally or perhaps more likely is that the Caspian Mates' coming energy wealth will create new economic and political strains that could hinder their iransformanon into stable and democratically oriented nations. Since ihe longer term pmipecu will be largely determined by decision! over ihe nest several years, whai regional leaders dowhat ihey don 1critical in shaping future economic growth and political stability.

The Downside* of Energy Wealth

Experience shows that, contrary to mosl expectations, large natural resource revenues frequently undercut economic growth and make economic reform and rcstruciuring more difficult. Nigeria, Venezuela, and Kuwail areew example* of oil-rich states whose per capita GDP actually fell inespite huge increases in oil prices and oil exportThe Caspian stales, especially Azerbaijan and Turkmenistan, appear vulnerable to many of the damaging effects of energy wealth since oil and gas will constitutearge share of iheir total exports. I

Impact of Energy Wealth on the

The Caspian stales, like other energy-rich developing countries, arc likely toonsiderable portion of their expected earnings forcommunications, power, andsocial needs

such as education and health. Despite these positive investments, there are several reasons why energy-rich countries often do not prosper but instead stagnate or even regress economically.|

"DutchNamed for the experience of the NetherlandsNorth Sea gas ins the energy sector grows, the non-energy economy often shrinks, largely due to an appreciating foreign exchange rate that makes exports less competitive on world markets. Underdeveloped financial markets in the Caspian states will make it particularly hard to channel oil and gas revenues into other sectors ofthe economy. As Dutch disease effects squeeze out domestic industries and agriculture, imports of food and other necessities often increase.

Nigeria, for instance, shifted from an exporter to an importernd

Expanded Government Role, Rapid growth of oil-derived governmentis likely to fuel economic centralization. Just as the Caspian states are moving tentatively awayovernment-run economy, intenseto spend their energy wealthacklog of unmet needs is likely to reinforce the role ofthe state. Azerbaijan, for instance, has to supportefugees and Is likely to use oil revenues to increase defenseto strengthen its position in its conflictmenia over Nagorno-Karabakh. I I

Distorted Economic Behavior. Oil revenues in other countries have diverted the economic focus from investment to distribution. This can greatiy increasea major problem in the Caspianproduce numerous "white elephant" projects. Kazakhstan and Azerbaijan face strong pressure to prop up noncompetitive Soviet-eraindustries that still have considerable economic and political clout

Vulnerability to External Shocks. Changes in oil prices and exportare often unpredictable, rapid, and beyond the control of any one state. Government revenues can decline precipitously, because die tax base is typically restricted to the coergy sector. Both Kazakhstan and Azerbaijan have already experienced this effect and have had to cut their government budgets, due to drops in oil prices over the past year.

mi on Economic Reform

To date,ountries have mixed performances on economicAzerbaijan and Kazakhstan have made some progress, but Turkmenistan has barely started The lack of reform will make it much harder io absorb energy wealth and. in lum, energy wealth will make further reform difficult by leading government and business leaders to believe thai they can afford to postpone the difficult decisions on economic reform, making them less prone to accept outside advice.

Dealing with oil windfall effects is difficult even for full-fledged market economies. Norway, for instance,harp growth inexpenditures and Dutch disease effects in the.

Implications for Economic Growth. Historical experience and CIA eco rtomic models suggest that the interaction of these elements couldreduce economic growth.

Per capiu CDP in Nigeria. Kuwait, and Venezuela stayed flat or actually fell in, despite large increases in oil export revenue*

Our modcU suggest that the negative impact of energy wealth on economic reform could similarly limit economic growth in the Caspian slates. According lo the models, growth in Azerbaijan could be so2it would not have recovered2 GDP levelo Kazakhstan. GDP would be onlyercent above2 level. For either country these would be disastrous performances lhal would not even keep up with forecast population growth

Turkmenistan is likely to be especially hard hit by tbe negative effectsmore lhanit does not haveinstitutions or leadership in place to effectively manage

The message ispoor transition coupled with Dutch disease and other negative effects can easily overwhelm most, ifnotall. uf the potential benefits of oil wealth.

Can These Problems Be |

In principle, many of these difficulties can be mitigated by correct policies. Government and nongovernment specialists agree ifui ihe relative succeu of countries that coped more effectively with oil windfalls innd

as Indoocsia. Malaysia andstepstrong, competent government could take. These include adhering to tight fiscal and monetary polices, encouraging privatization, setting aside part of the energy windfall by saving abroad, encouraging diversification of the economy, keeping expectations low, and bringing in foreign equity and advice. I i

Azerbaijan and especially Kazakhstan have shown some capacity to adjust policies in ways needed to offset die negative effects of energy wealth. All the Caspian states, however, face deep-seated political and culturallo reform, including limited cliie acceptance of market mechanisms, weak states and high levels of corruption, traditional cultures that do not distinguish between public and private interests, and the absence of reliable mechanisms for peaceful transfer of power.l i

If the Caspian states were to improve their progress on economicwell as take steps to counter the negative effects of oil wealth, bothexperience and our models predict substantial GDP growth rates.assume in our modeling dial exchange rates appreciate less, oilinvested productively, reinvestment is higher, and there ison economic reform, then Azerbaijan's GDP5 couldthan twoalf times2 level and Kazakhstan's almostas large.

Promoting Political Instability Q

No matter how effectively the Caspian states cope with these challenges, there will be fundamental political changes brought on by their oil and gas wealth. Leaders will want to use revenues both to shore up their own power and ensure stability andnot always compatible goals. These political pitfalls could exacerbate some of the more negative economic effects,

Income disparities and regime legitimacy. Deepening perceptions that narrow family and regional interests are benefiting disproportionately from energy investments could help undermine the legitimacy of existing leaders and contribute to the growth of opposition groups.

Riserentierhe authoritarian Caspian governments are increasingly isolated from domestic interests and broad social andrealities. Growing dependence on foreign-derived energy revenues would deepen this trend.


demembration, human rights, and rulc-of-law. Once Western investment in development and export routes is locked in. however, regionalof US support will shift and the United States may discover it has diminishing leverage on the political or economic policies of thesebut faces increased expectations.

Rising energy wealth is likely to make regional leaders more confident and less inclined to accept outside advice. At ihe same time, however. Caspian leaders may cxpeci ihe West to protect these investments,pipeline exportmilitary means ifto prop up increasingly unpopular political regimes. f-

Strong outside pressure for reforms from Western countries and financial institutions will be needed if the Caspian states areake ihe difficult steps necessary to overcome the negative effects of energy wealth.with the early results of energy development could lead towith Western advice and an inclination to blame the Western governments and private companies for any negative outcomes.

Development will not go smoothly even under the best of circumstances and the United States should be prepared for increasing social andstrains and periods of low economic growth.

instability, slow growth, and anti-Western sentiments could give more opportunity for meddling by regional powers such as Iran. Russia.

or China. P

Com rn b


Kiacrcecononuc Siahilirauon

OODOafc Krf.*m

Teuing Conventional Wisdom Aboutealth" Case 1 the "Convcnlionalil Helps Economic Omwih Casehe "Alternativenergy Wealth Pislucls Identic Growth rj _

l^MtCM Front Olher Energy

Vubverabiliiy o: ihe Caspian

Can These Problems Be Avoided?]

rhe Caspian

Casehe "Beanergy Wealth Harnessed k> Fccwrme

Impact of Oil Wealifa on Polnkal lastabiltfy and

Growing Incoine


Exacerbating Etfaak aad Regional

Cotnp)mating Trsnvfer ol

Outlook ft* ihe

Turkmenistan _

Implication* for US Policy: MoicChalienges

I men

Caspian Economics

Caspian Oil and Gas Production Set To Expend Future

aiipian Leaders on Future Oil Wealth [ |


EaogCTon* Variables j


This paper was written as pariroject in (he Directorate ofStrategic PerspectiveCaspian Region: Its Future Strategic Significance. It draws on extensive consultations with outside experts, starting with two conferences7 on the economic and political impact of oil wealth, and two workshopsne on the economic future of the Caspian states, and another on the strategic culture of the Caspian region. The projectinal paper sometime in the third quarter1 I

Trie purpose of this paper is io examine the long-term ecooomic future of the key Caspian states, and especially the impact of energy wealth- Analysis used econometric modeling, iworporaiing separate models of oil and gas production, to outline different options and identify critical factors. Many variables are discussed qualitatively and also incorporated quantitatively into the economic models. For instance, the model assumes thai high levels of corruption would reduce foreign investment and lower rates of-return. Political instability was postulated to reduce investor confidence, increase the cost of capital, and encourage movement of capital offshore. In other sectors, economic reform and rule-of-law helped attract foreign investment and improve rates-of-rerum. largely by ensuring properly rightsj

While it is clear that energy willowerful and someumes decisive influence on internal economic and political development, energy wealth alone will not determine ihe future of these slates. The appendix, foroutlines several significant external variables lhai may affect future development. These include world oil prices, the rate at which new oil is discovered, political and economic developments in Russia. Turkish energy demand, the Nagorno-Karabakh conflict, and Ihe evolution of IranianMany of these issues will be addressed in the final paper in this project.

'i|ir;in Stoles and Energy Wealth: New Threats to Growth and Stability! |

IM rTicuconomic Tasks

The Caspian stale*rhaiazakhstan, andall (he other newly independente faced tremendous economic challenges since the dissolution of ihe Soviet Union. They have had co achieve some mennire of economic stability while mating progress on ihe munitionarket based economic*.

Achieving Macrweonoaikzerbaijan. Kazakhstan, and Turkmentitan have workedt verve the drama tK econcKTUc declines thai followed the dissolution of the Soviet L'oioo

Azerbaijan and Kazakhstan are slowly recovering from Ihe precipitous falls in GDP in ihe early lo. according to official CIS Maliitics. However, Turkmen GDP fell by almostercent7 due primarily lo the less of in capon mule through Rusui for natural gas, according lo the IMF (see figure 11

Industrial and agrkuitural output are growingzerbaijan but area mwch-redaeed level fromKazakhstan

Hypennflalion in Ihes now underin Azerbaijan and Kazakhstan. Consumer prices in Turkmenistan, however, rose over BO percent

Turkmenistanarge external debt, and all three countries have been hit by last summer's Russian financial crisis Since men. Kazakhstan's currency has slowly depreciated. Azerbaijan'v has remained relatively stable, and, although Tnik mem nan's is greatly overvalued, the government has not permit-led any depreciation. (

All three economies arc still far below ihe economic levels they had attained on the eve of the dissolution of the Soviet Union. Kazakhstan and Azerbaijan arc suffering from the effects of the global economicespecially falling prices for oil and other commod-iiies, and the outlook for Turkmenistan is uncertain.

ut Making Slow Progress on Economic Reform

Among the major tusks lacing the three governments are privatizing state-owned enterpriwi. enacting legal reforms, reforming ihe banking sector, ending govern-mem subsidies, and liberalizing fcacign recent evaluations by the EBRD (European Bank ior Reconstruction and Development! and Freedom House, Azerbaijan and Turkmenistan fall well below the NIS average for economic reforms, while Kazakhstan is close to average (see

* Foreign trade bas been liberalized with iheof lariff rates but some Azerbaijani trading organizations function as de facto monopolies.1

large-scale state enterprises were privatized. Onlyercent of its GDP was produced in ihe private sector. I I

hat been more consistent in its reform suaicgy.

Ovej70percentofallenterpf:iesarc privatized although privatization of the larfer. and more"blue chip" enierprises has been delayed and much privatization Is in name only. Fifty percent of its output was produced in the pri tale sectorccordinghe EBRD

Legislation has been passed io improve ihcfor foreign investment but implememakon remains poor.

* The banking sector has also undergone substantial reform, including the consolidation of small unsound banks.

In contrast. Turkmenistan has generally shown limited imerest In economic reform and lhai has been reflected in its poor economic perforrnance.

urkmenistanomprehensive txooonuc reform package that included measures to partially liberalize the eschange system and ftanher decontrol prices, but the program has not been implemented.

By ihc endess than half of small state enierprises and practically none of ihe medium- and

'li'ilinu Conventional Wisdom

About knenty wtaath| |

Although mill struggling, the three Caspian stalesnocaJ asset not fouod in other trans:rvooing states" large potential oil and gas resources, whose esport potential (unlike thai of Russia, for instance) is only beginning to be tapped- To varying degrees, all three state* have brought in foreign investors to explore for and develop energy resources (see. |

Energy exports are beginning to increase (aftersharply in therogress in developing exportstates will begin to receive significant export earnings in another three to five years. The Caspian states have already begun io receive significant revenues from ihe sale of oil and gas rights and from direct foreign investment [

Conventional wisdom assumes that energy earnings will boost economic performance and growth,ihe prospects for social and political stability and progress toward democracy. The historical example of other energy-rich countries, however, suggests that energy wealth could have ihe opposite effect. To lest these propositions for Azerbaijan and Kazakhstan we have developed two economic models: one that

investment inflows and resulting oil and gas exports for both of these economies and another thai incorporates the revenue stream these energy exports produceeneral inodel of the entire economy. There is insufficient data available to produce amodel for Turkmenistan !

barrels per day currently toillion per day. The rise in production is driven by siillion in investments from international oil companies. Gas production, although less certain, is projected tofromcmtbillion cubic melers)em (sec

model projects oil production for the Caspianhole quadruplingrom lessillion


Figure 4

Caspian Energy

Ofl Production hy Cnunlrj

09 10 II 12 13 5

Million barrtll per aay

90 01 02 03 04 05 06 07

Gas Production by Country

cubic neten

024680 II llource: CIA and indwrrv rtrimate*.

Caspian Oil and Gas Production Stl lb Expand1

of long-term oil production vary widely and depend most importantly on ihe success of future exploration and the pent of foreign investment. Gas production will depend on the availability of export routes from Turkmeniiian and the pace ofodproduc-don in Azerbaijan and Kazakhstan] |

Oil Projections. In our baseline protection, interna-tsbnel od companies will tmeit about SIaspian projectsoosting regional oil output fromarren per day {h'Ji8illion bidhis (alls between theEnergyigh case projectionnd low ttue projectionnd compares wiih an estimateajor consulting firm. Production rises from5 in Azerbaijan, from85 in Kazakhstan, and from85 in Turkmenistan.

This forecast-developed-if* the lupfxui ofbasedodel shot combinesinformation oilfield cost figures, and production data *ith projections of annualthat oil companies are planning for Caspian projects. Investors have already announced plans to invest aboul SIOO billion in such projects.

The model indicates that future production is highly sensitive topen.eni increase in investment over the projected Siillion would

boost productionpercent shortfall would limit outputd.

Investment in exploration over the next five years wilt be criiieal. Projects now under development will drive production untilut subsequent gains will depend on prvjtcis stemming from exploration vet -lures. The site of new discoveries will alsompact on future production, most importantly

The discovery ofa field larger lhan Tengi; tn the North Caspian or AlOCs structure in the South Caspian would push our production foreranhigher. | |

Unpredictable variables such as oil prices and regional political suibility also will influenceflaws and development. Our projections assume that world oil prices over the forecast period will average SIS to SI8 per barrel in realthe average ofprices aver the pasl five

Gas Projections. Our gas production projections ere linked, tn the case of Turkmenistan, to ihe availob^lity of export outlets. We project that Turkmeniiiangas output will tlie from aboutcm per year6 to aboutcmhis assumes that Ashgabai will bexportcm per year tootal ofcm to Russia and Iran. In Kaiakhsion and Azerbaijan, matt gas production is associated with oil output and will be dmen by oilfield development We pevtcit gas production rising fromcm8 so aboutcm per year5 in Aurbaiyan and fromcm8 tocm5 In Kazakhstan.

energy exports. Most standard economic model* would predict major economic gains for ihe Caspian, especially since there are several other drivers ofgrowth besides oil and gas revenues.

High levels of unemployment could be reduced, ok) und inefficient capital stock could he replaced, and the low levels of factor productivity could be increased. | |

The Caspian states are unlikely lo reap full advantage of these factors, because, although the states have arrestedconomic declines, rhey have not made Ihe necessary progress on economic reform.if we assume that they can take partial advantage of Uscsc factors, that foreignhe wi sec-

Cat* I:il Help. Economic Growth] |

Thh case, which will be referred to as thein the following pages, is clow to what many observers and planners in the Caspian Males themselves see as the likely benefits from future

selves believe- growth is likely as the oil and gas sec-Ion pull the rest of Ihe economy along.'

Under these assumptions our models predict subtlan. tial economic growth over the nexl decadealf. Azerbaijan's GDP would growear over the nexl decadealf; Kazakhstan's,ercenl (see figureuch of this gain wouldecovery from the decline both countries ctpenenced from the early loGDP would not exceed2 levelzerbaijan* notGDP would be two-thirds more man2 level:hree-fourths more.

Not surprising!y. the model confirms (hai the Osi aad natural gas sectors are the fastest growing parts of the economy in both countries. The oil sector grows ataJmovtercent per year, tbe gas sector in Azerbaijan grows atercent per year, ia Kazakhstan atercent

ere about equal, although itssignificantly less Gas esports, assumingsolves the problem of an exportonsiderable revenue but probablyhalf the level Azerbaijan could anticipate fromTurkmenistan is also hkely io makeslower progress on economic reform j



ther fcoerg}

Empirical studies show that, contrary to most expects lions and ihe prediction* of most standard rnodcls. Urge natural resource revenues may actually undercut economic growth. The experience of countries rkh in oil and gas over the past V) years, particularly dunng the period of maior oil price increases io, shows thal--ilrpending on the magnitude of the dam-aging effects of oil wealih and ihe effectiveness of policyis possible that energy earnings may produce only sluggish growth, or lead to major eccoceiuc and social distortions that actually reduce growth from what ii would otherwise have been. Al threeponsored cceifcfencesxperts on the urspact of oil wealthariety of countr.esumber of leniencies that explain why

many oil-rich countries often do not prosper but

instead stagnate or even regress economkally.

"DutchNamed for the experience of ihe Neiheriands developing North Sea gas inarge foreign exchange inflows and increasing lax revenues from resource exports frequently cause the nonoil economyhrink, hugely due lo an appreciai-iag foreign exchange rate thai makes exports less competilive on world markets. The energy sector is typically an enclave thai depends on imported lech noiogy and skills, has few economic tankages with the .est of the economy, aod develops independently of it. As Dutch disease eflccu squeeze oca docoestsc mdu* tries and agriculture, imports of food and other neces sities often increase.

Nigeria, for instance, shifted from en exporter lo an importer of food0

To offset Dutch disease effects, governments fre. reave tariffs or adopt other measures lo protect and subsidize domcstk industries. Often, ihey never become competiuve on world markets.]

Diuoeied Economic Behavior. Oil revenues tend to divcri ihe economic focus from investment toand Soenotiece of i

since additional money is likely lo be readily available

favorable terms. Pouuca! considerations increasingly tend io lake precedence ova economic ones, leading to numerous 'Nvhite elephant" projects.^

Slowing of Economic Reform. Oil wealth lendK to reduce the pressure on government to manage resources effickmly. Government leaders and bureau -crais may come lo believe ihai ihey can easily afford to make some mistakes and postpone the difficult decisions on economic reform. They will be less prone to accept Western advice. Developmg the correct neo-ncenic policies so deal wirh ol windfall effectssf-rscuh task even for fan-fledged market rconoccjes

Norway, for instance,harp growih in government expenditures and Dutch disease effects in the.

Expanded GovernmentRole. Rapid growth ofoll-dcrised government revenues Is likely toat ton. Central government decision-makers believe that they have so many resources at Iheir disposal that ihey can solve any perceivedproblem rather than rely on market responses

Distorted Tax Structure. Developing slates withability to raise revenues through usual taxfind it relatively easy to tax highly concentrated and foreign-owned energy assets.5 Iran,Nigeria, and Venezuela received less than 5of state revenues from taxes on goods and services, compared to an average ofercent for nonoil developing countries. P

Vulnerability to External Shocks. Changes in ml prices and export revenues are often unpredictable, rapid, and beyond the control of any one stole Com-mitnxnu and indebtedness built up in boom periods become impossible to handle it oil revenues fall, often leadingicious cycle of increased foreignand dec lining income. Government revenues in particular can decline precipitously, since the tax base is typically restricted to the energy sector

Sharp oil price drops in theeduildup of foreign debt and in some casesto rioting and civil unrestumber of oil -neb countries, including Algeria. Nigeria. Mexico, and Venezuela

More recendy. the price drop in8 and9 has exacerbated financial difficulties even in major oil producers such asan, and Saudi Arabiaf

Vulnerability of Ihe Caspian States

Historic examples of poor performance by oil-rich stales show what could be in sieve for the Caspian region. Nigeria, Kuwait, aod Venezuela are only some of the oil-rich states with varying political andsystems whose per carats GDPi stayed flat or actually fell inespite large increases in oil export revenues (seehe cxient ofthe impart on the Caspian is likely to vary, depending on differences in tho structures of the economies and the size of the energy windfall. Inihe potential difficulties are greater when energy revenues are very Large compared to overall GDP and experts, as appears to be the case with Azerbaijan and Turkmenistan

Our model shows thai at their peak energy exports for Azerbaijanercent of total exports will be in

the same80some other states highly dependent on oil and gas insee

economy is much broader hau mr model shows that energy exports will be only slightly more thanercent of totaltherefore somewhat freer of the negative effects of oil wealth

comparison of the ratio of energy exports loGDPs yield similar results: Azerbaijan will earn over

ercent of its GDP from energy, according lo our model; Kazakhstan's energy sector will only be half that large Although wc could not modeldependence on gas exports, it has only one other majorits narrowly bated economy likely puts il in ihe same category as Azerbaijan or even worse.[

There arc other reasons lo believe thai the three Caspian states could be vulnerable to Dutch disease and iu related effects.

energy sectors have lewih the rest of the economy. Even Azerbaijan, which was ihe center of the USSR's oil services industry, produces little thai international oil companies are willing to purchase. Underdeveloped financial markets and lack of property rights in the Caspian stales will make il particularly hard to channel oil revenues into other sectors of the economy.

as the Caspian states are moving tentatively awayovernment-run economy, oil three states will face strong pressure to boost spending on infrastructure, social programs, and ecceiomic development. In addition, each state has specific rseeds. Azerbaijan, for insiance, is likely lo use oil revenues to increase defense spending, given the perceived threat from Anncnia.


Fljpare 6

Historical Growth Paths Tor Poor-Performing Oil-Rich QWBUllI,

and Azerbaijan face Wrong pressure lo prop upirjve Soviet-era inoVustrse* thai cannot be made profitable butave considerable economic and political clout. Kazakhstan haa no far avoided major irresponsible insestmeni protect* with one important exception, the move of ihelo Astsna and associated construction costs Costs for this effort have not been made public but

are estimated to be dose0 million. In Turkmenistan. Niyazov has spent lavishly on Prcsideniial palaces and personal luxuries.

We incorporated into our economic model the key cffecii of energy windfalls: an appreciating foreign exchange rate, difficulty in transferring the oil wind fall effectively to the other sectors, and excessive

government consumption and investment.and corruption mean that the transition process is managed even less effectively than in theview" case presented above: unemployment remains high, factor prcductivity grows even more slowly, and there is little reinvestment in the nonoil sectors. I

Under these assumptions, our models predict the growth rate of GDP would be less than half that of the "consentional view" case (seerowth io Azerbaijan would be solittle over 2it would not have recovered2 GDP


GDP GrowthCurhe Alternative View;

induslry output would growercent in Kazakhstan;ercent in Azerbaijan.

seems likely that Turkmenistan would behard hit by the negative etlects of energy wealth Turkmenistan doc* not have Ihe economic instiuiliorts or leadership in place to effectivelywealth from its gas resources!


These negative projections assume thai the oilto grow at almostercent.the negative effects of oil wealth becomebusiness climate coukl become so poor thatinvestors would stretch out Investments and,cases, withdrawIn thai case, thewould dm develop at the forecast paceGDP growth would be even lessoor transition coupled wisheffests can easily overwhelm most, if notdie potential riches from oil wealth.

Can These Problems be Avoided?

In principle, many of there difficulties can be avoided or mitigaied by correct government policies. Drawing on the experience of countries lhat coped morewith oilas Indonesia, Malaysia, andioumber of appropriate actions. All agreed, however,trong, competent gmvrnment isnot always suffuse nl -for sue-

auzhonianan. an unablermt interne pressurei to spend Oil wealth too autcU, and unwiselyhe following steps as essential to avoiding Dutch disease andnegative economic consequences.

Get the macroeconomic fundamentals right. Strong commitment to fiscal responsibility and acurrency are needed to counter the tendency of energy wealth to hike deficits and overvalue the exchange rate.

Plan ahead and save abroad. Government* should plan ahead for how to use energyuwuli and other slates, for instance, created mandatory funds for overseas investment lo remove revenues from the domestic economy and slow the rate of spending.

Diversify the economy Investment in other areas of manufacturing, services, and agriculture can offer greater gains than the energy sector and cushion the economy against ups and downs io oil prices. Irasooesia's relatively good response to oillor instance. Hemmed in large pantrong focus on agriculture.

Keep expectations low. Planners should useforecasts for energy income. To reducefor immediate spending, it is particularly important that leaders avoid raising expectations too high (see insei).

road awareness of the problem and make use of foreign economic and policy advice and expertisehould be aware of the! be rrcepi, ve to expert outside advice. Countries such as Indxmesia relied heavily on outsideesf loping their economies and allocating oil wealth.) |

The Caspian Case

There are several advantages the Caspian states have in handling Iheir energy wealth that may faciltiatc tuk ing the above steps.

and allow rents to flow to ihe private sector. The more economic decisions that are rnade by commercial rather than governmentthe better the oualiiy nf investments ise.

Bring in significant foreignignificant equity slake helps impose financial and marketon businew decisions and cushions some of Ihe domestic blow if revenues decline.

Low levels of political mobilization. The population is politically passive, and there are few organi/ed interest groups. Caspian goverarnents may have more leeway to spend weak* deliberately and resist special interest pressures lhan those in countries wiih entrenched interests and established patterns of exposition


Caspian Leaden on Future Oil Wealth I

his speech" Nazarbayev called for increating oil and gasto Improve peoples lives, but also said "Our national resources represent vast wealth. However, tsaradoxkal as it may seem, world experience shows that many countries possessing natural resources were unable to manage them properly and never got out of the category of

AliyevOne shouldober and objective view of this. The ordinary cltiien of AterbaifOn is gradually benefiting. It cannot happen that one day on ordinary Azerbaijani citizenarcel fmm the sky or from somewhere else with money ond oil andhere cannot be any leaps forward in the economy(Interview,

is not accidental that Turkmenistan is called abroad 'gashe enormous reserves of natural nscmrces.table political sttmuion saveot of painful moments in the transition toe fire marketInterview.

"We are the owners of resources for the world. The tolume of Turkmen gas isbdlion cubic meters. These rem quite enough for fiveod wilting, we shall exuactfromilium toillion tons of oil. This will give Turkmenistan greatSpeech,

states could gain by using energy wealth to modernize traniiportation, communications,health, and oiher systems.

lessons from previous oilhe experience of oil-nch countries deling the lastears of major oil price rises and falls provides some positivesuch as the steps outlined above io mitigate the impact of oil wcalih. The negativeIran,to counter ihe naturalto believe lhat oil revenues will solve all probierrts. Recent low oil prices, the globaldownturn. Lid use economic problems Russia and cither ml producers are now facingesult arc likely to reinforce this perspective with Caspian leaders.

Discrediting of statist economic solutions. During, when oil-rich states realized the steepest economic windfalls, socialism andationale for naoonaliring oil industries and using oil revenues io expand rhe state sector. Today tlx consensus among the international financial institutions, aid donors, and other sources of economic and political advke hiw moved strongly to market-driven, private, decentralized solutions to problems of economic development.

However, there arcumber of obstacles rooted in political and cultural charactenst ics of the Caspian states ihai will make it cnfficult for them lo effectively handle the challenges of energy wealth These are deep-seated conditions thai arc likely to change slowly, if at sit, in the near to medium term.

Economic decline and pent-up demand. The steep depression over the past eight years hasremendous backlog of needs coupled with great slack in the economy, as shown by high levels ofunderemployment. Even if significant amounts are lostorruption and inefficiency, ihe Caspian

Poor understanding of ond commitment to economic reform. As our model and historical experience demonsuate, progress on economic reform is crucial io avoid ihe more negative effects of energy wealth, but today's Caspian leaders are all former Soviet officials with limited exposure to Western economic experience. Although nominally embracing free market principles, tbe ruling elites are


with decentralized decisionmaking and private properrj ami do not understand iheeconomic system or how commercial firms operate Younger experts with Western training arc beginningmerge but do notajor rote in decisions. Of the Caspian states. Kazakhstan has the strongest commitment to reform; Azerbaijan, mixed acceptance; and Turkmenistan hasandful of officials wuh an understanding or appreciation of Western economics.

Weak turn and kigk levels of corruption. The Soviet legacy (which encouraged disrespect forandisaceical and cultural traditions, and the disruptions and weakening of government institutions dunng ihe transition have combined to produce very high levels of corruption in all three Caspian slates.

Islamic peoples wilh traditional culturesMoslem stales have had particular difficulty accepting and implementing economic moderniza-toon. In all three resurstnes regional, clan, and family linkagesajor role in business and politics, often undercutting efforts to implement Western modelsule-of-Iaw based on formal equality of individuals. Distinctions between personal .political, and business spheres are vague, and there is little acceptance of Western notions of "conflict-of-interest."

Authoritarian leodenhip and absence of reliable mechanismseaceful transfer of power. While the relationship between economic growth and democracy is controversial (development-oriented authoritarian systems have achieved high growth rates, especially Inany economist* agree thai political uncertainty can hamper economic growih by reducing investor confidence especially for small and medium-sue businesses andcapital flight. Tbe lack of internal checks and balances increases use chance of unpredictableshifts and greatly increases the risk of instability when it becomes neve wary in transfer


Caseh* "Bestr Harnessed Io FcorKtrnic Reform I

If the Caspian States were to improve then progress oa economic transition as well as take the difficult steps to counter the negative effects of oil wealth, both historical experience and our model predict GDP] growth rates substantially above the "conventional view" case. Per capita GDP fur strong pcrfotmeti such as Indonesia and Norway doubled00 (seef we assume lhal foreign exchange rates appreciate less, windfall gains invested more productively, reinvestment rates. higher, unemploy ment falls more, and capital is moreof which could result from mi improved performance on economic reform-model would predict

GDP growth ratesercent for Azerbaijan andercent for Kazakhstan Azerbaijan's GDP would be more than twoalf limes2 level, and Kazakhstan's almost three times as large (see.

AH sectors would grow al tapid rales led by the oil industry The nonoil industry sector would grow approximatelyerter* per year in Azerbaijanercent in Kazakhstan. Agriculture would grow atercent hi both countries. |

The cumulative effect of these high growth rales would outstrip population growih. thereby leading to substantial improvements in the standard of living in Azerbaijan and Kazakhstan. The gains might be even greater for Turkmenistan because il has the potential lo do so much "wrong."! I

Impact of Oil Wealth on Political Instability and Democratization

Whichever of die threehe "altemaiiser ihe "bestaccurately describe* these


Hblorical Growth Paitu for Well-Perform Lng CHlRkh Countries, |

Koocmic futures, oil and gas weahh will have Iniportaoi politicalreat deal will depend on the skill with which rulers distribute oil income. Tbe more it ii used to benefit ihc societyhole and in ways lhat unite ihese new nations, the less likelihood of social and political instability. However, negative economic and political trends can easily reinforce one anotheramaging cycle. Leaders will want lo use revenues both to snore up their own power and ensure siabitity andalways compauble goals. While political change will dependultitude of factors, not all

of which are considered here, we can identify aof the most important likely cfleets of

Growing Income Disparities

Income disparities, especially when visible and grow-tng. can encourage social unrest and politicalAlthough measuring the amount nf change is difficult, the gap between rich and poor haslmost all the post^ommumst stains as pan of the transition from central planning In the Caspian states, privatization has given major weahh producing assets


Figure 10

GDP GrowthCat*he Bert Case



B*vi Cm,

1} 5

a Mtiall number of wcll-cooneeled private owners. Poverty has dramatically increased (the share of the population in poverty, as defined by the UNDP, is close toercent in all three Caspiannd the social safety net is ia tatters wuh governments no longer able to pay salaries and pensionsegular basis.

Oil windlall* *re hkelv to exacerbate thismall group of elite owners and officials could realize huge gains, alongimited number of energy-sector workers, but the benefits to the bout of Use population -ill be limned and far below

popularit iitml would deepen per-cepilota lhai narrow interests are benefiting dispro-pomimatelyfrom energy Investments. The resulting resentment coulit help undermine the legitimacy of existing leaders and provide fertile ground for the growth of opposition groups. Q

unw n'niiiitesult of the jovcmment'i dependence on foreign-derived energy reven jes. it tends to become less and less answerable to domestic interests, more


and insular in it* decisioiuiiaking. and less aware of broad social and economic realities. The experience of Iran under ibe Shah show* ihe dangers this can pose in slates where the legitimacy of ruling el lies is not well established

This trend would further slow progress toward democracy and decentralization in the Caspian stalesspecially

Exacerbating Rthnlc and Regional Tensions

In states with strong regional or ethnic divisions, fights over the fair allocation of oil levenues con deepenn Nigeria, for instance, control over oil wealth between competing ethnic groupsentral role in the civil war of thend in subsequent political instability.

On the other hand, central genernrnents can use oil money to maintain liability by cementingand buying off potential challengers'.rjiegy can be effective as long at revenuesbut meansownturn in oil prices and revenues risks jpseUing the political balance.

In the Caspian, the division between ethnic Russians and Kazakhs in KacakhMan is the mosl serious potential split. In all three countries central leaders need io maintain support from key clans and regions and are likely to see energy wealtheans to ensurr/ politkal allegiance. These strategies will increase the tendency to make political rather than economic goals decisive in spending decisions.

Outlook for Ihe Caspian Slates[

In all of the Caspian slates, oil and gas earningsgreat wealth, some of which will be usedand socially productive ways.will also intensify many negative trends andproblems. Prediction is very cornplKaied andchoices and quality of leadership will make aThe three Caspian states also differin Iheir perfortnance to date on the keyby experts as essential for avoiding theconsequences of energy wealth (see figuregiven curreni trends and the relativelyin which to set countries on she right course,to long.term omliookfor sustainedis closer tothe 'alternativeCase lithe "conventional new' / Thedemocratization and political stability are

Kazakhstanpolicy course is likely to be mixed but it will have i'tme leeway in coping with problems and more ability than the other states to adjuM to changing circumstances. Pluses are consistent forwardon economicelatively large and diversified economy, limited dependence on energyealthy and dynamic leaderong-term perspective, rnacroeconomic stability, andexposurehe West. Minuses are increasing corruption andarrowing political base for die regime, lack of true private owners and the prevalence of industrial dinosaurs, latcni ethnic splits, deep poverty, and public pessimism on the economy.

Transfer of Powrr Increased economic centralization and government control of the economy would make it leu likely that rulers will agree to voluntarily relinquish posser.developed private sector, ruling elites see ccsrrcrol of the state as rhe only reliable way to accumulate wealth and status. The political scene con-tinues to he dominated by clan-based politics^-


Atta will face much greater challenges in dealing with energy wealth. Pluses are rapid development of tbe oilrowing Western presence. Ahycv's strategic vision and political skill, and macroeccasorroc stability. Minusesess diverseigh degree of future dependence on energy exports,and value-sublracling heavy Industry.

Aliyev's age and probable decline coupled with lack of planning forarge refugee population, an unresolved conflict with Armenia, limited progress on reforms, deep-seated corruption and nepotism,ecent history of civil strife. I


Turkmenistan is not in position to deal competently with energy wealth Issues. Minusesery narrow economicigh degree of likely dependence on energyighly traditional and fragmented social structure, extreme concentration of power and suppression of opposition, limited capabilities of the leadership and ruling elites. Niyazov's questionable heal tli, lack of economic reform, recent economic decline and balance-of-paymem problems, and extreme corruption and ostentatious concentration of wealth.

There is an appreciable likelihood that an economic tailspin will occur,olitical challenge to whomever is in power. The almost complete absence of any organized political opposition could make it easier for Niyazov to weather any oear-term challenges,ess well-entrenched successor might be more vulnerable I

Implications for US Policy: More Challenges Ahead! I

Rapid growth in energy wealth will challengein promoting regional independence,economic development, and globalOver ihe nest several yean, thehase of developing energyestablishing exportew focusenergy wealth and building economicinstitutions The earlier lhal regionalthat they need to shift their locus andio use energy wealth wisely, rhe bene*of

This new phase will change tbe nature of thewith die United Stales. Up until now. Caspian leaders have lendedee their relationship with the United Stalesargain in which US support for

investment and independence is weighed against US pressure on dcmocratization, human nghts. and nale-of-Urw. Once Western mvestment in development and expon routes is locked in. however, regionalof US support win shaft and the United Stats may discover ii has diminishing leverage on theor eccmoeruc policies of ttascccxincnev bul faces increased expectations

Rising energy wealth is likely to make regionalmore confident and less inclined to acceptadvice,

Western engagement, particularly thai of the United States, has been crucial in helping the Caspian snues find appropriate export routes. US companies have been in the forefront of efforts to develop Caspian energy resources, aod tbe United States has lakes Che lead in promnnng regional energy devekspracat projects such as the Baku Ceyhan pipeline, tbe TuTimerunan-Turkey gas pipeline, and resolution of Caspian Sea boundary Issues.

* Caspian leaders may expect the West to protect these investments, including pipeline export routes, by military means if necessary and to prop up increasingly unpopular political regimes. | |

Given the internalhe Caspian stares willard time taking the necessary steps on their own to overcome die negative effects of energy wealth. Western advice has already produced some appropriate actions for instance, the IMF recently made Azerbaijanlanning group for moire energy incomeondition for further assistance.

To continue to be effective, outside advice on howandle energy wealth should be ccordinaied and cons'isieni. Western governments interrurtional financial inflations, and major Western investors must send similar messages to reluctant Caspian ebtesjj

Disappointment with the results of energycould lead Io greater criticism of the Westodel Ifc* development and specific disenchantment with ihe United Stales. It would be unrealistic to expect development to go smoothly even under the best of circumstances, and there are likely to be increasing social and political strain; and periods of low economic growth.

Given its heavy engagement in energy development, the United Stales will likely be portrayed asfor any negative outcomes.

Disappointment with ihe results of Westerncould make leaders more reluctant to accept advice on other issues, including economic reform and democratization.

and other foreign investors could face political aad popular pressure to re-negotiate contracts if the high expectations of energy development are not realized.

powers suspicious of Westernas Russia, Iran, orbe likely to try and exploit instability and any anti-Western sentiment.

A full assessment of the strategic Implications of the development of Caspian energy wealth will be addressed in other papers to be produced in thisPerspective Series (secuch anwill dependost of exogenous factors (see the appendix) in addition to the factors analyzed tn this paper]



Exogenous Variables

paper focused on factors thai are internal to ihe Caspian (tales and largely under the controlarge number of factors outside their control could also affect their long-termfurores, f"

Global Financial and Fnrrgy Markets

Poor global economic performance would lower energy demand and keep oil prices low. This would reduce revenues in two ways: by lowering the amount earned for energy exports and lowenng the amount of energy available and, possibly, energy export capacity by reducing or stretching out die time for investments.

Caspian oil is relatively inexpensive to develop and produce because of (be large field sues and nigh well product)vines, but high transportation costs make invest menu, there sulnerabic lo sustainediaicetq

Tbe return of Iraqap* oil exporter or theby Saudi Arabia and other Gulf states to greater foreign participation in upstream oil development could also contribute to downward pressure on prices. Our baseline case assumesrecovery of oil prices and continued strong Investment However, the loss of revenuehe Caspian economies would be offset in paneduction in Dutch disease and othereffects of oil windfall'

OuVGas Discoveries

The model incorporates conservative estimates of future discoveries. Greater- lhao-ex peeled discoveries over the next several years could accelerate ihe impact of eecrgy wealth by fueling additional foreignand increasing public expectations. This would be reflected in our model by an increase in near-term invest ment and more rapid growth in prcdueuon and export earnings. Lower- lhan-expected discoveries would work in the opposite direction.

Regional Demand for Gas

Gas demand in growing markets, especially Turkey, is the key driver for building major gas export lines. There are major unccrtamnes associated with

projecting demand, however, and if il is lower lhan expected or Turkeyeriod of prolonged eto-nomk or political instability, prospects for gas exports, especially from Turkmenistan, could be reduced. Turkmenistan would face much-reduced exports and/or rhe need to accept less favorafcac terra for exports lo Russia or Iran. | |

Russia's Fxonomlc and I'oliIleal Future

Conunued recession or economic collapse in Russia could negatively affect the economy of Kazakhstan but would haveinimal direct impact in Azerbaijan or Turkmenistan gjven iheiromic ties toeakened Russiaess political and economic leverage in use region. Ifeplacedore aggressive and naoooal-ist leadership, regional leaders would be more ested in maintainingS support andrade-off might heed Western pressure on political. economic re form*.[

Regional Conflicts

A resumption of fighting in Nagorno-Karabakh could result from an Armenian desire to disrupt pipeline plans andealthier Azerbaijan from build ing ap its military, oresult of miscakulanon by either sideeriod of increased instability In post-Aliycv Azerbaijan, economic development in Azerbaijan and the region generally would be set back as Azerbaijan diverted resources Io security, investor confidence fell, and pipeline and uanspunaiion projects Ihroughout the Caucasus were canceled of delayed.

More Moderate Iran

A cccrtirtualioo of moderating trends in Iranian poll would make it easier to reach solutions to oil. export probknw but could shin some investor im away from the Caspian to Iran. Tensions between Caspian stakes, Turkey, aad Russia over pipeline rentes could increase if obstacles to Iranian export routes are removed. [


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