A quarterly magazine of the IMF

December 2006, Volume 43, Number 4

Straight Talk

The Great Game Again?

Countries seeking economic security by acquiring commodity producers risk violating good business sense

Raghuram Rajan

Some commentators see the desperate search by countries to acquire commodity-producing firms in other (typically poor, developing) countries as a repeat of the Great Game—the tussle among powers like Britain and Russia for influence in the Middle East and Central Asia during the 19th century. In this view, those that acquire the greatest share of commodity producers early on will enjoy the greatest economic security in the future, as growth in China, India, and other populous developing countries creates shortages of commodity resources. Economic security is the new justification for purchases, such as minority stakes in opaque companies in poorly governed countries, that would otherwise make little business sense. In this replayed Great Game, will those who move fastest and farthest acquire the most economic protection? Does the gain from economic security trump common business sense?

A questionable buying spree

I'll leave aside the question of whether we're inevitably headed for a sustained period of commodity demand outstripping supply, even though in the past such predictions have proved unfounded. Let me take as given that such an eventuality is possible. To simplify the argument, I'll assume that state-owned companies undertake the acquisitions and that all income and value obtained flow directly to the citizens of the acquiring state—a questionable assumption at best. Even under these strong assumptions, should a country go on an acquisition spree to protect itself?

Precisely how an incipient imbalance between demand and supply would play out matters. Consider the most likely situation, where a world market for a commodity—let's use the example of oil in what follows—continues to operate. If there's an incipient imbalance and oil is in fixed supply in the short run, the market price for oil will shoot up so that demand is brought down to equal supply.

How does ownership of foreign oil assets help? One might think that a country that owns foreign oil can use the profits from sales to keep its domestic price low and thus insulate the economy from high oil prices. But this doesn't make economic sense. The market price of oil reflects its opportunity cost. Rather than subsidize the price in the domestic oil market (and thus give domestic manufacturers and consumers the incentive to use too much oil, given its true cost), it would make far better sense to let the domestic price rise to the international price and distribute the windfall profits from oil sales to the population.

Put differently, suppose the country exported widgets that it manufactured in an energy-intensive way. It would be politically convenient to avoid layoffs and continue competing in the widget market by subsidizing the oil price, using the financial leeway from foreign oil assets. But this would eat up the oil windfall by subsidizing both inefficient manufacturing and foreign widget buyers. A more economical decision would be to shrink widget manufacturing (or shift to new technologies) and use the windfall to make transfers to citizens, especially those most affected by high prices. These citizens would thus receive additional income when the price of oil rose: they would be hedged.

The key point is that fundamental economic decisions shouldn't be affected by the ownership of additional foreign oil assets. However, because of pressure exerted by small, powerful, affected interest groups, politics will intervene and oil windfalls will inevitably be spent in unwise subsidies. As a result, the acquiring country will, if anything, make suboptimal economic decisions because of the financial windfall available through hedging.

But let's assume the country always makes the right economic decisions. Does hedging lead to more financial security? A hedge will always look beneficial if one looks backward after the price has risen. But if the price of oil had fallen, citizens would have suffered a loss of income and wealth from having bought foreign oil assets (relative to having instead invested the money elsewhere). Assuming the foreign oil assets were priced fairly at the time of purchase, the country benefits only when the hedge helps smooth its income and wealth. This isn't obviously true even for a country that relies heavily on oil.

For instance, in a large country like the United States or China, which account for a significant portion of world demand, the world price of oil is likely to be high when the country is growing strongly and citizens have lots of income, whereas the price is likely to be low when the country is doing poorly. Foreign oil assets are a bad hedge in such a case for they subtract from citizens' income when it's already low and add to it when it's high. Indeed—and this may seem heretical—the country might be better off selling its domestic oil assets to foreigners and investing the proceeds in non-oil assets.

Even if owning oil assets is a useful hedge (as in a small, oil-consuming country), it's not clear that buying stakes in opaque companies in poorly governed foreign countries is the way to go. As the oil price increases, a poorly governed country is more tempted to expropriate foreign owners of its oil industry through extortionary taxation or nationalization—especially if the domestic public feels, with the benefit of hindsight and populist egging, that the assets had been sold too cheaply in the past. The security of a country's ownership of oil assets in poorly governed foreign countries likely diminishes when the oil price rises.

Planning for a bleak world

How then should a small country hedge oil price risk? Liquid, oil-linked financial securities in well-governed financial markets, such as oil futures traded in developed markets, make the most sense, but not enough is available very far out. There do, however, exist liquid, long-dated, oil-linked securities—the equity of large oil companies. So, without being facetious, perhaps the best advice I could offer countries seeking to hedge oil price risk is "Buy Exxon shares!"

If economic security isn't the reason, why would a country want to buy large interests in poorly managed oil companies in dangerous locations? It might make good business sense—the target is poorly managed and can benefit from the know-how and management the acquirer provides. But, then, this is a sound business case for buying the asset untainted by specious claims of enhancing national security. It's important that the target's price not fully discount these future managerial improvements. For instance, targets in countries that are international pariahs may be attractive for acquiring countries that are still willing to do business with them because the acquisition price may be extremely low. Otherwise, it's hard to see how the acquirer will escape the customary fate of acquisitions: they typically overpay and lose money in the long run.

Other reasons are less good. One is that countries fear a total market breakdown and descent into an autarkic "Mad Max" world in which oil is scarce, no country is willing to allow trade in what it has, and there's no world market clearing price. It's not clear that, if such a situation were to come to pass, ownership of oil assets abroad would help. Most likely, the governments within whose borders those assets lay would expropriate the assets. Each country would have only oil assets that are physically within its political borders. Indeed, to protect against such a bleak world, a country would do well to increase exploration, the use of alternative energy sources, consumption and production efficiency, and the storage of reserves within its own borders (regardless of who owns the assets) while increasing the economy's flexibility to respond to oil supply disruptions.

Even in such a bleak world, it's hard to imagine the market breaking down totally or for long. Indeed, one can imagine black marketers and smugglers buying where oil is cheap and transporting it to sell to countries where oil is costly. Unless governments build leakproof barriers around their countries—the costs would likely be prohibitive—an implicit world price would be reestablished. We would then be back to the case we've already examined.

Another bad motive might be that state-owned commodity companies are flush with profits that they'd otherwise have to return to the government. What better way for management to spend those profits than to build foreign empires, justifying the acquisitions with the time-honored "it's in the national interest"? Of course, sweetening any such rationale would be any "under the table" payments to acquiring managers if the transaction is nontransparent.

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The best way to secure the supply of a commodity is to ensure that the world market for that commodity is well informed and competitive and that the business environment is transparent and predictable. Information on reserves and investments helps market participants make sound business decisions. Competition keeps participants honest and prices informative, and allows consumers to reap the benefits. A predictable business environment allows businesses to invest for the long term. Transparency not only reduces the costs associated with corruption but also protects businesses from future accusations of having obtained overly sweet deals.

The bottom line is that the new mercantilism—I own more of others than they own of me—appealing as it may be, is not going to lead to more national security. Countries are collectively most secure if the control of productive assets is in the hands of those who can manage them best. Indeed, anyone who takes or keeps control of an asset that someone else can manage more productively is contributing to both individual and collective insecurity. The Great Game exacerbated insecurity even as each power tried to secure itself. Let's hope that better sense will prevail this time.