Economic diversification has been a policy priority for low- and middle-income economies for decades, as it is closely linked with structural transformation from lower to higher productivity sectors as well as to economic development. Unfortunately, diversification continues to elude many African countries, which remain heavily dependent on the export of a handful of non-renewable resources. Consequently, Africa is home to eight of the world’s 15 least economically diversified countries. The figure below illustrates this phenomenon. Lack of economic diversification not only weakens the foundation of African countries’ structural transformation, it also makes them particularly vulnerable to sudden external shocks and slows their development. The pandemic-induced oil price crash, which saw crude oil entering negative territory, and the crisis in Ukraine, which has caused a sharp spike in global oil prices, are two examples of commodity price volatility that may have an impact on African resource exporters.
Commodity price swings are of particular concern to African policymakers, as natural resources account for the lion’s share of many African economies, including their export earnings and government revenues. And, as the world transitions towards more sustainable energy sources to fight climate change, countries that depend on carbon-intensive industries risk facing severe economic hardship. Some African countries—such as the Democratic Republic of the Congo (DRC), which has the world’s largest reserves of cobalt—could potentially benefit from the green energy transition. However, many more—including Algeria, Angola and Nigeria—are heavily reliant on hydrocarbons production and could see their exports plunge as a result of the green transition. In these countries, economic diversification is more crucial than ever.
Though diversification is key for sustained growth, low-income, resource-rich countries—many of which are located in Africa—face distinct challenges in their endeavour to diversify their economies. First, low-income countries often depend on subsistence agriculture or the production of specific mineral commodities, and even when they achieve higher levels of economic growth and move towards middle-income status, there is no guarantee that their economies will actually diversify. The wealthy yet economically undiversified Gulf states are a prime example of this phenomenon. Growth alone is not enough to achieve economic diversification.
Second, given their reliance on natural resources such as petroleum, minerals and agriculture products, resource-rich countries tend to be less diversified than their resource-poor counterparts and thus more susceptible to external shocks.
Finally, government effectiveness is positively associated with both economic diversification and growth, but is negatively correlated with resource wealth, compounding the challenges resource-rich countries face.
Considering these constraints, countries seeking to diversify their economy must decide which direction to take. One question policymakers must address is whether to expand their activities in existing economic sectors that offer “room to grow” or to create entirely new ones. Existing economic sectors tend to drive the bulk of economic diversification in middle-income countries. This might entail moving up the value chain by engaging in higher productivity activities such as food processing, mineral beneficiation or petroleum refining. On the other hand, the addition of new productive sectors that contribute to the economy is important in the early stages of economic development, and is particularly crucial in driving the transition to higher income levels. This might entail prioritizing previously underdeveloped industries such as financial services, logistics or construction. Evidently, these two processes—adding new sectors to the economy and promoting diversification in existing ones—vastly differ in practice, and necessitate different policy agendas, resulting in distinct outcomes.
Expanding existing industries or creating new ones takes years, if not decades. But one thing governments can control is how they raise revenue and, more immediately, how they spend it. From a policy perspective, fiscal diversification is perhaps the most urgent task of diversifying the economy. This is especially true given the fact that both government revenues and expenditures are positively correlated with economic diversification.
In addition to choosing the scope of their diversification objectives, policymakers must adopt suitable policies that will drive these objectives. They include a wide range of monetary, fiscal and industrial policies, which must be tailored to the country’s specific characteristics and needs. Beyond maintaining price stability, sound monetary policies can help avoid extended periods of currency overvaluation and facilitate export diversification. Appropriate fiscal policies can foster productivity-enhancing and market-creating initiatives, and thus advance diversification. Likewise, industrial policy is also crucial by integrating trade facilitation with measures to attract capital in specific sectors.
Economic diversification policies and their implications: the Botswana and Nigeria case
The cases of Botswana and Nigeria, which adopted different policy solutions to implement their economic diversification agendas, shed light on the policy constraints governments face. Botswana, for example, focused on the management of its diamond industry revenues and sustained a per capita growth rate of around 6 per cent, accompanied by a reduction in poverty levels to less than 20 per cent. This was achieved through robust macroeconomic policies that helped avoid the worst impacts of the Dutch Disease; a public financial management framework that guided the investment of revenues; and the accumulation of foreign reserves, including a well-managed Sovereign Wealth Fund (SWF). Nevertheless, diamonds still account for 80 per cent of Botswana’s exports and 60 per cent of the country’s government tax revenue.
From the early 2000s onward, Nigeria has introduced extensive reforms that enabled economic growth. Sound monetary policies helped stabilize the Nigerian naira for a while. Economic liberalization spurred the emergence of new economic sectors and contributed to attracting private capital. Fiscal reforms helped make oil revenue management more transparent. Nigeria was able to achieve strong growth levels for over a decade and reduce the oil sector’s outsized contribution to its economy. Yet these reforms did not suffice to drive structural transformation and diversify Nigeria’s export and government revenue sources. Though the oil sector only contributes around 10 per cent of Nigeria’s GDP, it accounts for over 90 per cent of the country’s exports and 50 per cent of government revenues.
As the cases of Botswana and Nigeria demonstrate, governments face trade-offs when adopting diversification policies. Important structural differences have implications for how countries pursue the policy objective of economic diversification. Furthermore, national governments have little immediate control over many of the factors that can lead to diversification—at least in the short term. Patience, continued prioritization of economic diversification, and a stable political environment that can ensure policy continuity are key for countries seeking to diversify.
Disclaimer: The views expressed in this article are those of the authors based on their experience and on prior research and do not necessarily reflect the views of UNIDO (read more).
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