Benefication Is Not A Free Lunch!
Recent research argues that Mozambique’s gas and coal resources create a competitive advantage in energy-intensive products, opening up a completely new source of production and exports (Standard Bank 2014). As a consequence, it is proposed that benefication, moving downstream into processing of these resources to promote greater value added, offers an obvious path to structural transformation and industrialization. Further, it is maintained that these benefication investments would act to counter-balance any negative Dutch Disease effects that might arise because of booming natural resource exports.
The basic idea behind such claims is that it is a logical, natural progression for a country exporting raw materials to move into downstream processing, and, therefore, policies encouraging such a step can induce and accelerate industrial development and economic diversification. The cornerstone of this notion is the premise that vertical relationships in production chains, known as linkages, can be a key driver of the development process. The importance of linkages in economic development was popularized by Hirschman in his influential 1958 book on development policy, “The Strategy of Economic Development.” He argued that investing in industries with the greatest backward and forward linkages would have the most powerful total effect on economic growth and development, as it would induce a broad set of continuing responses. In Hirschman’s own words, “economic development is a process of one thing leading to another”.
This idea influenced to two popular policy strategies based on linkages: (a) import-substitution, which sought to induce investment, structural transformation, and growth via backward linkages to final demand and (b) benefication of natural resources, which often aimed at restricting exports of unprocessed resources in one part of the value chain to encourage development of downstream industries in another part of the chain. These policies were fashionable with policymakers in developing countries for most of the 1960s and 1970s. By the 1980s, however, backward-linkage strategies, such as import substitution, had not lived up to expectations. Forward-linkage strategies, on the other hand, have continued, and recently picked up momentum in the wake of the commodities boom. In Sub-Saharan Africa (SSA), for example, Botswana initiated a forward linkage-based strategy to encourage downstream processing of diamonds; Ghana has promoted processing of gold; Gabon targeted downstream timber businesses; Nigeria directed its efforts at fostering both forward and backward linkages in oil production; South Africa has developed an extensive initiative to beneficiate mining; Tanzania has supported gold processing; Zambia has promoted a forward linkages in the copper industry; and Zimbabwe has instituted policies to launch downstream processing in chrome and platinum. So, Mozambique is not be alone in the region in thinking a forward linkage strategy to increase domestic value added of natural resources and promote structural transformation of the economy.
However, is such a strategy based on sound economic principles? Is benefication a good model for promoting value added and industrialization in a country at Mozambique’s stage of development? Hirschman defended forward linkages based on encouraging the development of related industry. Other advocates have argued that physical proximity to resources provides downstream processors with economic advantages because of transportation costs. Still others, maintain that local resource supply is more secure, and, more importantly, cheaper for downstream businesses. Moreover, some claim that proximity to the upstream resource allows the input to be more precisely matched to downstream producer needs.
These pro-benefication arguments do not make as much economic sense as they did in the past. Transport, information, and communication costs have fallen dramatically over the past several decades, and continue to decline, making processing near the raw material less important. Falling transport and ICT costs, as well as declining tariff barriers, have also resulted in increased supply chain fragmentation, and greater trade globalization, reducing the need to develop a whole industry supply chain domestically. Given these changes in world markets, high forward-linkage possibilities no longer automatically convey an advantage to developing resource-based production. Forward-linked industries can be established in any country able to import unprocessed resources. Only if home country processing can supply the downstream product at lower cost is it advantageous to invest in developing the industry at home.
The cost factor in this calculation is determined by comparative advantage and technological ability. Mozambique’s endowments and technological capabilities at this stage do not give it cost advantages in highly capital-intensive processing industries, such as those linked with coal and gas. Downstream businesses in these supply chains (a) require huge capital investment (for example, capex for a fertilizer plant is about $2bn, a methanol plant around $5bn, and a GTL plant $19bn), (b) necessitate large complementary investments in public infrastructure to make them viable, (c) call for highly technical skills to operate them efficiently, and (d) employ only a small number of workers.
Downstream processing businesses in coal and gas are also not particularly profitable – in most cases, they only just cover long-run marginal cost, with significant positive and negative fluctuations around its trend, and they do not contribute much to value added. To have any chance of consistent profitability, these businesses need to be situated near large consumer markets, or have some other similar competitive advantage. And this assumes reasonably good operating conditions. Should there happen to be any adverse operating circumstances, one could end up with a situation similar to that of oil industry benefication in Nigeria, where mismanagement, corruption, and other problems often cause the country’s four downstream oil refineries to operate at less than 50 percent capacity, forcing Nigeria to import significant amounts of high-priced petrol. What is more, projections indicate that there will be excess capacity in global markets in oil and gas processing businesses in the coming years. A number of producing countries around the world, particularly in natural gas, have made downstream processing investments and there are more on the way (assuming oil prices do not decline too much). Considering all these issues, it might be more cost effective to simply import rather than deal with the high capital costs, technical problems, management issues, complementary infrastructure demands (and often pollution) involved in downstream processing at home.
Advocates, however, take things a step further, arguing that access to gas at cost of production makes benefication a “no-brainer”. Unfortunately, it is not that simple. Subsidizing such a key input to downstream processors (private or public) is not only fiscally costly (the gas could have been sold on world markets for a much higher price); it also has efficiency implications, in that a subsidy encourages adoption of production technologies that are overly energy-intensive. The situation becomes more problematical if gas prices should rise, pushing up the value of subsidies (just ask Venezuela, or Nigeria, or Indonesia), or when gas production runs out, leaving the country with an inefficient, subsidized processing industry (and related businesses), which provides only a small contribution to GDP and few employment benefits.
While benefication of energy-related natural resources does not look particularly promising in Mozambique at this juncture, there may be other situations where such investments make economic sense. To make a case for promoting such downstream processing projects, an appraisal should show that: (a) there is a competitive home production cost advantage, other than simply the availability of the upstream resource, (b) there are significant end-user markets for the product, (c) there is private management and capital motivating the investment to maximize operational efficiency, (d) there are minimal public subsidies involved in making the downstream investment economically viable, (e) there is a reasonably good fit with local skills, technological capabilities, and available infrastructure, and (f) there are indications that the project will enhance local skills development and correspond with government’s priorities of promoting more inclusive growth and poverty alleviation.
In view of the fact that an important objective of benefication is to promote structural transformation and industrialization, the question arises as to whether there is any evidence indicating that such forward-linked investments actually work? Do they routinely stimulate a self-sustaining succession of related industrial activities? Sadly, the track record of benefication in most SSA countries does not promise much success in this area. Studies show that benefication policies in most SSA countries have had significant problems generating a continuing upward spiral of industrial development (see for example Morris et. al. 2012). Related industrial activity has not broadened or deepened significantly in most cases. Linkages to benefication investments continue to be quite limited – more so than in most other regions of the global economy. In Angola, Botswana, and Tanzania, emergence of related industrial linkages to benefication has been sparse, even after a number of years of promoting such efforts. In Gabon and Ghana, while some related linkages materialized, they remain weak. Nigeria has had some success developing backward linkages, for example in logistics and oil services, but not much success with forward-linked efforts. Similarly, in South Africa, where the industrial base is more advanced, competitive backward linkages have developed in mining equipment and in technical mining services. Downstream benefication efforts, however, have not always delivered desired results, owing to problems with complementary infrastructure and skills gaps.
Why hasn’t one thing led to another in most of these countries? The stated reasons for lack of success of benefication in jump-starting industrialization are not surprising. In a number of cases, benefication has had to rely on extensive government intervention – subsidies, mandates, regulations, and substantial complementary infrastructure investments – to make downstream processing economically viable. After propping up initial benefication investments, however, there was anemic follow-through on efforts to further support development of related business activity: inadequate supporting business environment policies and poor policy implementation; lack of sufficient training to address large existing gaps in basic skills; inadequate infrastructure and poor management of existing infrastructure; and lack of interest of the lead firms investing in extraction of upstream resources (e.g., lead firms often did not have adequate cooperative programs to assist in fostering local linkages – for example, assisting in developing local sourcing of inputs). In the policy area, an illustration of what went wrong is highlighted by how local content regulations were implemented in many instances. Just about all of the SSA countries studied had introduced local content regulations to compel foreign firms investing in resource extraction to develop local sourcing linkages. Many SSA countries, however, mixed together local-content policy to promote domestic value added with indigenization policy to transfer ownership of foreign investments to local citizens. In the end, only minimal support went to efforts to encourage local value added. And, when they did promote development of local value added, public support programs often overreached, selecting related businesses for promotion that were well outside the grasp of local capabilities.
The lesson to be drawn from all of this is that, for benefication to have a positive impact on structural transformation and industrialization, much more needs to be done than simply promoting a downstream processing investment. Generating related business linkages to benefication requires a concerted strategy, including a supportive policy and regulatory environment to encourage linked business development, together with an array of complementary investments in infrastructure, skills development, and a national system encouraging technology transfer and adoption. Moreover, it will necessitate significant improvements in the public investment management system to enhance public implementation capabilities in all these areas.
Plainly, forward-linked benefication investments appear wanting, in several respects, as a policy paradigm for promoting industrialization. So what might be a better approach? Extractive industries like coal and gas create other positive linkages that can be attractive targets for investment promotion, as illustrated by the cases of Nigeria and South Africa, discussed above. Firms supporting oil, gas, and mining activities have emerged, via backward linkages, in these countries around the extractive sectors, assisted by policy initiatives. These competitive linkages range from logistics, to specialized engineering and construction, to dedicated banking services. Industry clusters that have developed in these areas (a) are not capital intensive, (b) provide jobs that assist in building world-class skills, and (c) connect well with the rest of the economy. All things considered, targeting such backward linkages for support would seem a much better model for future industrial policy in Mozambique than forward-linked benefication investments.
Gynberg (2013) “Some Like Them Rough: The Future of Diamond Benefication in Botswana,” European Center for Development Policy Management.
Morris, Kaplinsky, and Kaplan (2012) “One Thing Leads to Another: Promoting Industrialization by Making the Most of the Commodity Boom in SSA,” University of Cape Town, South Africa.
Standard Bank (2014) “Mozambique LNG: Macroeconomic Study,” Maputo, Mozambique.