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What’s is: Dutch Disease is a term that describes an economic phenomenon when the exploitation of natural resources triggers weakness in other sectors, especially manufacturing. An increase in income from the exploitation of natural resources will result in an appreciation of the exchange rate, making domestic products, mainly from manufacturing sectors, less competitive in the international market.
The history of Dutch Disease
This term first appeared in The Economist magazine in 1977. The magazine analyzed the Netherlands’ economic situation after discovering a large natural gas field in 1959.
At that time, the Dutch economy increased its income from natural gas exports. This resulted in a significant appreciation of its currency due to a massive influx of capital into this sector.
But, due to the focus on natural gas, other sectors are less developed. Ultimately, the unemployment rate is higher in the country, and the manufacturing industry declines.
Dutch Disease causes
Dutch Disease is generally associated with countries whose economies are heavily dependent on exports of natural resources. For example, Indonesia.
This phenomenon is a paradox of the concept of comparative advantage. In the comparative advantage model, each country must specialize in an industry with a comparative advantage over other countries.
However, such advantages do not work well with resource exporting countries.
These countries try to exploit natural resources when global commodity prices increase. They ignore the development of other sectors.
Commodity prices cannot sustain a country’s economy in the long run. It can fall immediately when demand in global markets weakens, for example, due to recession.
The sudden explosion in the exploitation of natural resources increases the demand for labor in this sector. The workforce usually comes from industries such as manufacturing.
And, then commodity prices fall, they become unemployed because firms are cutting jobs. They also may not be able to flexibly move to other jobs due to inadequate skills. Hence, they may be unemployed for longer.
The economy then experienced a sharp fall in income, which could not be compensated for by rapid growth in an already weakening manufacturing sector. The effects may be long-lasting or possibly brief, depending on the severity.
Dutch Disease examples
Several countries may suffer from the same syndrome, such as Mexico, which experienced an oil boom in the ’70s and early ’80s.
This phenomenon has also occurred in Indonesia. The boom in commodity prices after the 2008-2009 crisis made Indonesia too focused on commodity-based sectors. The downstream commodity industry is underdeveloped.
Then, when commodity prices fell in 2015, Indonesia’s economy was stuck at 5%. Tax revenues are not on target because, so far, they have depended on levies from the commodity sector.
The next effect is deindustrialization. The manufacturing sector’s contribution decreased from year to year. It makes various manufactured goods less competitive in the global market.
How to avoid Dutch Disease
There are various options for dealing with the Dutch Disease phenomenon. Four of them are:
- Slowing down the rate of appreciation of the domestic currency
- Economic diversification
- Growing national savings
- Investments in quality production factors
Slows down the rate of exchange rate appreciation
Slowing currency appreciation is a more accessible and feasible strategy to prevent the adverse effects of the Dutch Disease phenomenon. For example, this step could be achieved using the income generated from the export of natural resources for investment.
One of the common methods of doing this is creating a sovereign wealth fund (SWF). The SWF is to sterilize large investments into the booming sector by keeping a portion of this new revenue abroad. Furthermore, countries can decide to slowly repatriate these savings for various purposes, for example, infrastructure development.
As it aims to stabilize capital inflows and prevent a significant appreciation of the currency, SWF usually invests overseas in a non-domestic currency. For example, Norway transferred a portion of the revenue flowing from oil sale to assets denominated in foreign currency.
There are many examples of SWF. Among them are the Australian Government Future Fund, the Government Pension Fund in Norway, the Iranian national development fund, the Stabilization Fund of the Russian Federation, the State Oil Fund of Azerbaijan, and the Alberta Heritage Savings Trust Fund of Alberta in Canada. You can view the SWF ranking on the Sovereign Wealth Fund Institute homepage.
Diversify the economy
Economic diversification is the next strategy to minimize the negative impact of Dutch Disease. But, such a strategy requires a fundamental approach that may not be suitable for every country. Also, this strategy usually takes a long time.
Economic diversification can be achieved by subsidizing lagging economic sectors. The government can also set tariffs to restrict imports and support domestic producers, especially those in the non-commodity sector.
Growing national savings
Another approach is to grow national savings. This can be done by implementing measures that encourage consumers and firms to save more or reduce the government’s budget deficit (or increasing its surplus).
An increase in national saving reduces dependence on foreign investment in growing the economy. The higher the saving rate of a country, the greater the loanable funds.
Investments in the quality of production factors
The government can also invest part of the revenue to increase the quantity or improve the quality of production factors. For example, through:
- Education and training
- Research and development
- Infrastructure
This ultimately increases the productive capacity of the economy. Education and training, for example, increase productivity through improved skills. It also increases labor mobility.
Infrastructure such as roads and railways is also essential to reduce logistics costs. It was ultimately the manufacturing industry to remain competitive in the international market.