Managing a Bauxite Discovery in a Low-Income Country
A low-income country with GDP of $30 billion and a population of 20 million has discovered a bauxite deposit. Projected government revenue is $1.2 billion per year for 20 years, about 4% of GDP. Current government spending is 3% of GDP on education, 2% on health, and 4% on infrastructure. Primary school completion is 62%, child stunting is 28%, and youth unemployment is 25%. The mining project is an enclave: 80% of workers are foreign, and non-mining exports are 12% of GDP. The government is debating whether to deposit the revenue in a sovereign wealth fund or spend it immediately on schools, clinics, and roads. A real exchange rate appreciation of 10% is forecast if the revenue is spent domestically.
1. Evaluate the spend-now versus save-now options using opportunity cost, absorptive capacity, and intergenerational equity. What decision rule would you recommend?
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The revenue is large relative to the economy-4% of GDP-so spending it all immediately risks exceeding absorptive capacity. Schools, clinics, and roads require planning, procurement, and skilled staff; a rapid surge can drive up construction costs and create white-elephant projects. A 10% real appreciation forecast would also hurt non-mining exporters. But saving everything is hard to justify when primary completion is 62% and stunting is 28%. A reasonable rule is to save a substantial share, such as half, in a sovereign wealth fund for future generations and fiscal stabilization, while spending the rest on high-return, maintenance-intensive human capital and rural infrastructure. The spending should be phased through a medium-term framework with published selection criteria. Intergenerational equity argues for saving part of an exhaustible resource; opportunity cost argues for spending where social returns exceed the return on foreign assets.
2. Explain the Dutch disease mechanism in this case and identify two policies to mitigate it.
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Dutch disease works through the spending effect and the resource-movement effect. The mining revenue increases domestic demand for goods and services, especially nontradables such as construction, services, and housing. Their prices rise, and the real exchange rate appreciates-here by a forecast 10%. Non-mining exports, only 12% of GDP, become less competitive, while capital and labor move into mining and nontradables. Two policies: first, save part of the revenue abroad in a sovereign wealth fund or sterilize the inflow to limit the domestic demand surge. Second, invest in infrastructure and education to reduce supply bottlenecks and raise productivity in tradables, and use a fiscal rule that caps annual spending growth. A flexible exchange rate can also absorb part of the adjustment.
3. Discuss how the quality of institutions and transparency should affect the government's choice. Include one specific accountability mechanism.
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Institutions determine whether the revenue becomes productive investment or rents. If procurement is opaque and audits are weak, immediate spending is likely to leak into inflated contracts and patronage. Strong institutions would favor gradual domestic spending with rigorous appraisal. A specific mechanism is publishing all mining contracts and payments under the Extractive Industries Transparency Initiative, with an independent oversight board that includes civil society and local governments. Ring-fencing the wealth fund and requiring legislative approval for withdrawals adds a check. If institutions are weak, the safer course is to save more abroad and transfer a smaller, rules-based amount to the budget, while building capacity before scaling up spending.