Dutch disease refers to an economic situation that is observed in countries which are abundant in natural resources. Owing to this, these economies are mostly inclined towards the export of the resource, leading to a current account surplus and a rapid appreciation in their local currencies. This rapid appreciation leads to the exports from other traditional sectors becoming non-competitive in the market – the net result being that the economy becomes overly dependent on a single sector with high price sensitivity. The term was originally coined in 1978 by the Economist to mark the decline in the manufacturing sector in the Netherlands after the discovery of natural gas.
However, if we consider the same in another perspective, it also apparently gives a country a huge deal of negotiation power and leverage in international relations (Oil diplomacy, perhaps?). Let us assume an oil rich country X with currency C. The international prices of oil are denominated in USD, whereas the current account for country X is denominated in the local currency C. As C will tend to appreciate, the price of oil will also have to rise in USD to ensure that the current account surplus is maintained and it does not result in translation losses for country X. Thus, setting in motion a natural contango for oil prices. Contango refers to an economic situation where future prices are greater than current spot prices. Russian oil boom can also be attributed as example of Dutch disease.
What happens when the country X runs out of resources? The country will have to continue to reinvest its earnings during the entire course of natural resource lifecycle into areas which can serve its growth story later- for instance, Dubai is looking to position itself as a major tourism and health city once it exhausts its oil reserves. The reinvestment of funds at high pace will lead to a sudden boom in the local economy coupled with not just an appreciating currency but also with rising prices of basic goods and commodities. Owing to this high pace of development, the shortage in skilled human capital will be met with infusion of large migrant workforce. However, once the resources are exhausted the incomes will fall back to normal levels and might lead to an economic cycle bust in case the transition is not complete.
Another interesting development that can be viewed in relation to the Dutch disease is the practice of Oil loans, i.e. soft loans against the value of oil exported. China has been following this strategy for funding infrastructure projects in energy rich Africa and Latin America. It serves two purposes: It helps in providing it energy security while also helping to utilize its excess capacity. While the loans may work perfectly fine in a normal market, in case the market enters into backwardation it can lead to serious impact on both sides, resulting in a possible downgrade for the exporting country.
It is largely owing to this phenomenon, the manufacturing sector in oil rich middle-east countries mostly remains competitive owing to the subsidies given by the local governments. In fact, most of the export oriented industries in the Middle East are located in Public Free Zones where they get access to both duty free exports and imports. International trade agreements also play a significant role, for instance the existence of the Multi Fiber Agreement pre-2005 led to the growth of textile and apparel manufacturing in the middle-east.
The problem with this kind of growth can be prevented by either slowing the flow of funds or by increasing the savings rate in the exporting country, which is achievable by curbing exports and by investing the proceeds overseas in the form of sovereign funds. Furthermore, in case the investments are made in the direction of human capital or towards technological progress, it might lead to a more sustainable growth in real GDP.
Perhaps the only possible and viable solution to the Dutch disease is rather than export, if the country itself becomes the consumer of the resource. In such a situation the volatility in the resource price does not impact the economy while at the same point of time the high convenience yield for the resource helps in boosting the manufacturing sector by reducing input costs. For instance, China though being rich in natural resources is not prone to this phenomenon as it largely consumes it on its own without any exports. Smaller resource rich countries should look at forming economic blocks and counter the Dutch disease in order to build a sustainable economy and may also look at having a common currency if needed. Furthermore, the blocks should be formed in a manner whereby the member countries are rich in resources that have little correlation to each other.[/sociallocker]