Dutch Disease

What is Dutch Disease?

The apparent causal association between growth in one sector's economic development and a deterioration in other sectors is known as the Dutch Disease. 

Dutch Disease is a word used in economics to describe the negative effects that might result from a sudden increase in the value of a country's currency. It is largely linked to the discovery or exploitation of a rich natural resource and the unanticipated effects that such a discovery might have on a country's entire economy. 

When raw commodities become scarce, the economy may find itself in a worse position than before. 

If a country discovers large quantities of oil, gas, or another natural resource, it will begin to export these items, resulting in a significant growth in GDP, which will boost tax revenues, improve the current account, and generate jobs.

However, countries that have discovered such natural resources have profited far less than we might think.

Although Dutch Disease is often linked to the discovery of natural resources, it can also emerge from any event that leads to a substantial inflow of foreign cash, such as a rapid increase in natural resource prices, foreign aid, or foreign direct investment.

So, in a nutshell, the contradiction that happens when good news, such as the finding of enormous oil reserves, damages a country's larger economy is known as Dutch Disease.

It may start with a significant infusion of foreign finance to capitalize on a newly discovered resource. A rising currency value causes a reduction in exports and the loss of jobs to foreign nations as symptoms.

In the long run, when manufacturing jobs migrate to lower-cost nations, these factors may contribute to unemployment. Non-resource-based industries, on the other hand, suffer as a result of the greater income created by resource-based companies.

Dutch Disease History

After the discovery of major natural gas resources in 1959, The Economist magazine used the phrase "Dutch Disease" in 1977 to describe the economic condition in the Netherlands. 

Although natural gas exports enhanced the Dutch economy's income, the huge appreciation of the national currency as a result of the big capital influx into the sector led to a greater unemployment rate and a fall in the manufacturing industry.

When a country contracts Dutch Disease, the conventional export industry is driven out by the other two sectors, according to a classic article by Corden and Neary (1982).

W. Max Corden and J. Peter Neary, two economists, created the basic economic model in 1982. A non-tradable sector (which includes services) and two tradable sectors are represented in the model: the booming sector and the lagging (or non-booming) tradable sector. 

The exploitation of natural resources or the cultivation of crops such as coffee or cocoa is generally a growing industry. Manufacturing or agriculture is frequently the sector that lags.

The term has become popular in economic circles to describe the paradoxical scenario in which seemingly positive news, such as the discovery of enormous oil reserves, has a detrimental influence on a country's overall economy.

In the context of origin, the word alludes to the negative impacts on manufacturing industries that occurred in the Netherlands following the discovery of natural gas in the 1970s and the subsequent process of real currency appreciation. 

Following the oil price shocks of the 1970s, numerous oil-exporting countries had similar "diseases," adding to the increasing literature on the issue.

A natural resource boom comes dangerously close to becoming a curse in this literature because specialization in natural resource-intensive industries can be deleterious to long-term growth.

Dutch Disease Effects

Simple trade models imply that a country should concentrate on industries with a comparative advantage. For example, a country wealthy in natural resources would be better off focusing on its extraction.

Other ideas, on the other hand, argue that this is harmful, such as when natural resources are depleted. Therefore, the effects would be:

• Costs may fall, and competitive manufacturing may not be able to return as rapidly as it went. 

• This might be because technical growth in the booming and non-tradable sectors is lower than in the non-booming tradable sector. 

• Because that economy's technical progress was slower than other nations', its comparative advantage in non-booming tradable products shrank, causing businesses to avoid investing in that area.

• Furthermore, volatility in the price of natural resources, and hence the real exchange rate, restricts private sector investment since businesses will not invest if they are unsure about future economic conditions.

• The value of the currency rises as a result of commodity exports such as raw materials. This contributes to a lack of competitiveness in other areas of the economy. 

• Natural resource exploitation is also exceedingly capital intensive, resulting in the creation of few new employment.

• Through a variety of factors, the expansion of a natural resource-intensive export industry can push out the manufacturing sector.

• The rise of the natural resource sector increases labor demand in the industrial sector, raises wages, and decreases profitability. Manufacturing's profitability constraint inhibits capital accumulation and growth.

• As natural resource rents rise, demand for non-tradable products rises, resulting in a higher relative price for non-tradable items and, as a result, real currency appreciation. The increased demand for and pricing of non-tradable goods causes a shift of labor from production to services.

• The reduction in manufacturing profitability will force capital to flow towards non-tradable products and resource-intensive industries. This is referred to as indirect deindustrialization since it is produced by real currency appreciation due to the spending impact and is dependent on the currency's strength.

Dutch Disease Problems

It is frequently difficult to determine whether a country has Dutch disease since the link between an increase in natural resource income, the real exchange rate, and a drop in the trailing sector is difficult to show.

A few of the problems related to this disease are:

• Increased luxury imports: As the production of discovered natural resources increases, people who profit may spend more on luxury products and services. Because these high-end items are typically imported, domestic businesses profit little.

• Inequality of income: The discovery of raw minerals, such as oil, usually benefits just a tiny portion of the population. Owners of oil resources can amass an enormous fortune, but the advantages of oil and gas are not always evenly spread across society. 

• Indirect-deindustrialization: As manufacturing becomes uncompetitive as a result of increased exchange rates and salaries, production and investment will fall, resulting in weaker growth.

• Increased competitiveness: Due to the increased exchange rate, manufacturing industries will face a significant drop in demand. As a result, the economy will move away from industry and agriculture.

• Currency appreciation: The country's exchange rate will appreciate due to the discovery of natural resources and a rise in exports. Because rising demand for exports leads to greater demand for the currency, this is the case.

• Income from natural resources: The large output of natural resources might result in significant tax revenue for the government. The government may run a budget surplus and spend more on public services like infrastructure and education. However, the government will frequently reduce other taxes to depend more heavily on natural resource tax receipts.

Examples of Dutch Disease

Economists in Canada claimed in 2014 that an infusion of foreign money associated with the development of the country's oil sands may have resulted in an overvalued currency and a deterioration in manufacturing sector competitiveness. Simultaneously, the Russian ruble gained a lot of value for the same reasons. 

The price of oil fell dramatically in 2016, and the Canadian currency and the Russian ruble also fell to lower levels, relieving fears of Dutch disease in both nations.

The Mexican Oil Boom was a period of high oil prices in Mexico from 1977 to 1981, which led to a terrible fall that lasted for the majority of the 1980s, forcing the economy into debt and a massive deficit adjustment when oil prices plummeted.

When the price of oil tripled in the 1970s, it became economically possible to drill for North Sea oil off the coast of Scotland, causing Dutch Disease. 

Britain, which had previously been a net importer of oil, had become a net exporter by the late 1970s. Despite the rise in the value of the pound, the UK entered a recession as British workers sought greater salaries and Britain's other exports became less competitive.

Following the supply of substantial quantities of relief and recovery aid, such as that that occurred in various parts of Asia following the Asian tsunami in 2004, there were post-disaster booms followed by inflation.

During the 16th century, gold and other valuables were carried from the Americas to Spain and Portugal, leading to a price revolution that linked to the high rate of inflation.

The impact of North Sea oil on industrial sectors in Norway and the United Kingdom from 1970 to 1990 resulted in energy booms that harmed manufacturers. Demand, supply, and oil price shocks are three more forms of structural disruptions recognized in addition to energy booms.

Strong foreign exchange market inflows into the Philippines in the 2000s resulted in currency appreciation and a loss of competitiveness. Strong foreign cash inflows, according to monetary officials, are beginning to stress the Philippine economy, necessitating quick action.

How to Avoid Dutch Disease?

It is frequently difficult to determine whether a country has Dutch disease since the link between an increase in natural resource income, the real exchange rate, and a drop in the trailing sector is difficult to show. 

However, upon detection, slowing the real exchange rate's appreciation and increasing the competitiveness of the adversely impacted industries are the two most fundamental approaches to lessen the threat of Dutch disease.

There are different ways to prevent the disease; some are:

1. Reduce foreign capital flows: When a country transitions from a budget deficit to a budget surplus, it attracts fewer foreign investors to buy government bonds. The increase in the currency rate would be limited by lower capital inflows.

2. Immigration: Many oil-rich nations have promoted immigration to fill service-sector employment, which has slowed real wage growth.

3. Sterilize the boom revenues: Instead of bringing all the income into the nation at once, some of the revenues should be saved overseas in special accounts and brought in gradually. This can be politically challenging in developing nations, but this ignores the wider macroeconomic ramifications.

4. Increase saving: To minimize huge capital inflows that may cause the real currency rate to appreciate, the government should encourage people to save. A country's requirement for loans to support government deficits and foreign direct investment can be reduced by growing savings.

5. Higher taxes: More taxes on luxury imports would prevent the economy from being overly tilted toward luxury services, which would be unsustainable in the long run.

6. Investment: Investing in education and infrastructure can help a lagging industrial or agriculture sector become more competitive.

Another strategy is for the government to boost subsidies or tariffs in the underperforming industry. However, because big inflows of foreign money are often given by the export sector and purchased by the import sector, this might exacerbate the consequences of Dutch disease. 

Summary

The phrase "Dutch Disease" refers to an economic phenomenon in which the extraction of natural resources causes weakness in other sectors, particularly manufacturing.

After the discovery of the enormous Groningen natural gas field in 1959, The Economist used the word in 1977 to characterize the demise of the industrial sector in the Netherlands.

A rise in revenue from the exploitation of natural resources will cause the exchange rate to appreciate, making local products, particularly those from the manufacturing sector, less competitive in the international market.

Natural gas exports enhanced the Dutch economy's income. As a result of the large infusion of cash into this industry, the currency appreciated significantly.

Other industries, however, are less developed as a result of the reliance on natural gas. In the end, the country's unemployment rate rises, and the industrial industry suffers.

It's usually connected with countries whose economies rely significantly on natural resource exports.

Several nations, including Mexico, which had an oil boom in the 1970s and early 1980s, may be affected by the same disease.

Indonesia has also seen this issue. Following the 2008-2009 financial crisis, commodity prices soared, causing Indonesia to become too reliant on commodity-based industries. The downstream commodities business is still in its infancy.

Some of the prevention methods include reducing the pace of appreciation of the home currency, increasing national savings, and investing in high-quality production elements.

Research & Authored by Ankit Sinha | LinkedIn 

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