POVERTY THE WORLD BANK REDUCTION AND ECONOMIC MANAGEMENT NETWORK (PREM) Public Disclosure Authorized Economic Premise JUNE 2010 • Number 16 Dealing with Dutch Disease Milan Brahmbhatt, Otaviano Canuto, and Ekaterina Vostroknutova 1 Public Disclosure Authorized This note looks at so-called Dutch disease, a phenomenon reflecting changes in the structure of production in the wake of a favorable shock (such as a large natural resource discovery, a rise in the international price of an exportable commodity, or the presence of sustained aid or capital inflows). Where the natural resources discovered are oil or minerals, a contraction or stagnation of manufacturing and agriculture could accompany the positive effects of the shock, according to the theory. The note considers channels through which such natural resource wealth can affect the economy. It also focuses on the development implications of Dutch disease, particularly the potential negative effects related to productivity dynamics and volatility; and concludes with a summary of possible policy responses, including the mix of fiscal, exchange rate, and structural reform policies. Public Disclosure Authorized The recent boom in primary commodity prices has once such as increasing returns to scale, learning by doing, or pos - more stimulated interest in the issue of “Dutch disease.” This itive technological externalities. Concerns about Dutch dis - term refers to changes in the structure of production that ease may also arise in the context of large, sustained private are predicted to occur in the wake of a favorable shock, such capital or foreign aid inflows (Auty 2001). as discovery of a large natural resource or a rise in the inter - This note lays out a basic model of Dutch disease, follow - national price of an exportable commodity that is perceived ing Corden and Neary (1982), and considers channels to be permanent. Such structural changes are expected to through which natural resource wealth can affect the econ - include, in particular, a contraction or stagnation of other omy; it focuses on the development implications of Dutch tradable sectors of the economy; and to be accompanied by disease, particularly the potential negative effects related to an appreciation of the country’s real exchange rate (Gelb productivity dynamics and volatility; and it concludes with and Associates 1988). Where the booming sector is oil or a summary of possible policy responses, including the mix minerals, the declining tradable sectors would include man - of fiscal, exchange rate, and structural reform policies. ufacturing and agriculture, according to the theory. In prin - Public Disclosure Authorized ciple, such changes in the structure of production should be A Model of Dutch Disease welfare improving, reflecting changes in demand associated with an improvement in national income. They may, how - When studying Dutch disease, researchers typically model ever, be a matter of concern for policy makers if the declin - the economy as consisting of three sectors: the natural re - ing sectors are thought to have some special characteristics source sector, the nonresource tradables sector (usually un - that would stimulate growth and welfare in the long term— derstood as agriculture and manufacturing), and the 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise nontradables sector (including nontradable services and con - more open to capital flows and in relatively less capital-in - struction), as presented in Corden and Neary (1982). The tensive manufacturing sectors, consistent with the theoreti - prices for both the natural resource and nonresource trad - cal model developed in the study. ables sectors are set in the world market, and those in the One of the measurement issues with Dutch disease is the nontradables sector are set in the domestic economy. The difficulty in finding the counterfactual size of the tradables real exchange rate is defined as the price of nontradables rel - sector—that is, determining how large the tradables sector ative to the price of tradables. There generally are two types would have been in the absence of the natural resources. We of effects leading to Dutch disease and real exchange rate use the Chenery and Syrquin (1975) norms approach to es - appreciation: timate a norm for the size of the tradables (manufacturing 1. The spending effect comes into play when increased do - and agriculture) sector by country income group over time. mestic income from the booming natural resource sec - Figure 2 shows the difference between the actual size of the tor leads to higher aggregate demand and spending by tradables sector and the Chenery-Syrquin norm. For the the public and private sectors. Increased demand for nontradables leads to higher prices and output in the nontradables sector. Wages in the economy will tend Figure 1. Terms-of-Trade Shocks and Real Appreciation, 2004–08 to rise, squeezing profits in the nonresource tradables sector (“manufacturing”), where prices are fixed at in - 0.6 ternational levels. 2. The resource movement effect takes place when a boom 0.4 R in the natural resource sector attracts capital and labor E E R from other parts of the economy. It tends to reduce f o 0.2 output in the rest of the economy. In particular, re - g o l n duced output in the nontradables sector causes the i e 0 price of nontradables to rise relative to the price of g n –0.4 –0.2 0 0.2 0.4 0.6 0.8 1.0 a tradables, which are set in the world market. This ef - h c fect in less likely in low-income economies, where –0.2 most inputs used in the natural resource “enclave” are imported from abroad. –0.4 Both effects result in a fall in the output share of nonre - change in log of terms of trade source tradables relative to nontradables, and a real exchange rate appreciation—that is, a rise in the price of nontradables Source: Authors’ calculations, using the International Monetary Fund’s relative to that of tradables. Information Notice System. 2 What about empirical evidence? There is relatively robust Note: REER = real effective exchange rate; y = 0.3825x + 0.0481; R = 0.2364. evidence that terms-of-trade increases cause real apprecia - tion in natural-resource-rich countries (for example, see Spatafora and Warner [1995]). Figure 1 displays changes in Figure 2. Dutch Disease Measure for Resource-Rich and Other real effective exchange rates compared with terms-of-trade Countries, 1975–2005 changes, and it reveals a correlation during the recent episode of high commodity prices. 0.05 The evidence on the shrinking of the manufacturing sec - 0 tor in response to terms-of-trade shocks and real apprecia - P D G tion has been somewhat mixed (Sala-i-Martin and f –0.05 o t Subramanian 2003). Recently, though, much stronger evi - n e –0.10 c dence of Dutch disease is presented by Ismail (2010), who r e studies the impact of oil price shocks using detailed, disag - p –0.15 gregated sectoral data for manufacturing and allowing for the possibility that the extent of Dutch disease will depend –0.20 5 7 9 1 3 5 7 9 1 3 5 7 9 1 3 5 7 7 7 8 8 8 8 8 9 9 9 9 9 0 0 0 9 9 9 9 9 9 9 9 9 9 9 9 9 0 0 0 on the capital intensity of the manufacturing sector and the 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 economy’s openness to capital flows. Ismail finds that, in year general, a 10.0 percent increase in an oil windfall is associ - ated with a 3.4 percent fall in value added across manufac - resource rich other turing sectors. Such effects are larger in economies that are Source: Authors’ calculations, based on Chenery and Syrquin (1975). 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise purpose of this figure, resource-rich countries are defined as Figure 3. Manufacturing Growth and Resource Exports, Selected those in which the resource sector produces more than 30 Economies g percent of GDP. On average, the tradables sector in such 0 n 7 HKG i r 9 u 1 SGP countries is lower than the norm by approximately 15 per - t BEL TAI c n i a NLD cent of GDP. f e u IRL MYS r n JPN PRT CAN a a FRA h BHR m s TUN ISL HTI f Development Implications of Dutch Disease l USA o a MUS OMN i IND t h i t MEX n i w PRY QAT o x r In general, an increase in wealth resulting from the discovery SAU s g VEN t f r KWT o of a natural resource or a permanent rise in the terms of o p GHA LBY g x o e trade is a positive development: it leads to a new equilibrium l with higher incomes and higher consumption of both non - log of natural resources exports as a share of GDP in 1970 tradables and tradables (the latter supplied to a greater ex - tent than before through imports). Moreover, rents from Source: Sachs and Warner 2001. mineral resources collected by government can provide re - Note: y = 0.74x – 7.49; R 2 = 0.26. sources for investment in public goods and other develop - ment expenditures that would have been unaffordable in different circumstances. Analyzing the historical develop - GDP in a cross-section of countries during 1970–90 was as - ment of several European countries and the United States, sociated with reduced manufactured export growth (figure Gelb and Associates (1988) conclude that “there is evidence 3) and with as much as 0.4–0.7 percentage points lower an - that, at least in some cases, high-rent activitie s..