EI Sourcebook | 8.5 Absorptive Capacity

8.5 Absorptive Capacity

While a significant allocation of EI sector revenues to spending and especially to domestic investment is desirable, the effectiveness of that spending will depend to a large degree on the absorptive capacity of the resource-rich economy. A rapid buildup of spending in response to a revenue windfall is likely to be highly inefficient as the economy will face absorption problems. The spending path needs to be set at a rate that is efficient for the economy.

Absorption difficulties often arise at the institutional level in many developing states as a result of limited capacity, which can limit government in its ability to identify and implement policies and projects that are a cost-effective use of resources. If investments are badly chosen or badly executed, the state will have wasted a unique opportunity for transformative development. White elephant projects and half-completed investments are all too common. Serious absorption challenges are also likely to exist at a macroeconomic level.

A rapid escalation in spending can be expected to put upward pressure on domestic prices. This can result in a real appreciation of the exchange rate; loss of competitiveness of non-resource exports, and as a consequence, loss of economic diversity; and a large negative impact on overall economic performance. This describes the problem known as Dutch Disease, which is described earlier in the Source Book (see Chapter 2). Good practice in response to absorptive capacity issues involves credible commitments to improvements in public expenditure management, (see Chapter 9) and a gradual buildup in expenditure.

Experience suggests that both expenditure smoothing to address volatility concerns, and a gradual expenditure buildup in the face of absorptive capacity constraints, suggest that part of any resource revenue windfall should be allocated to saving.^[7] Saving of resource revenues may also be justified on other grounds (such as a precaution against unforeseen negative events or to generate wealth for future generations in anticipation of the eventual depletion of resources). The next two sections discuss two important savings options.