‘’Dutch disease’’ of the resource paradise

Virus symptoms

In the modern economy, we have such an extraordinary term as “Dutch disease”. The symbiosis of medicine and economic symptoms in the definition excites the imagination. However, the truth is banal. The “Dutch disease” refers to a decrease in the efficiency of the country's economy due to an increase in the export of country’s raw materials without processing. However, according to the Oxford business dictionary “Dutch disease” - is the de-industrialization of the economy because of the discovery of a new source of natural resources. Therefore, this phenomenon is inherent only in industrialized countries. In world practice, an analogue of the “Dutch disease” for countries with virtually no industry — is also known as the “African syndrome”. Undoubtedly, the “Dutch disease” is a complex and even more interesting phenomenon. De-industrialization of the economy - the result to which leads the influence of many "symptoms" inherent in it.

The term first appeared in the publication of The Economist magazine in November 1977, which was dedicated to the discovered link between the increase in natural gas production in the Netherlands and the decline in industrial production in that country. The “Dutch disease” is a negative effect of the strengthening of the real exchange rate of the national currency as a result of the natural resources mining boom and the illusion of temporary deflation. The boom may be caused by the discovery of mineral deposits or a rise in prices for exports of the extractive industries. The sharp increase in export revenues in the 1970s led to the inflow of foreign currency into the country (the Netherlands), which caused a strengthening of the national currency - the gulden. In addition, the growth of household incomes created additional demand for goods and services, which led to higher prices (inflation) and an increase in imports. Foreign goods became more accessible to the population than local ones, and local industry began to experience difficulties with sales both domestically and when exporting goods (as opposed to raw materials). This, in turn, led to an increase in unemployment in the industrial sector. As a result, against the background of rapid growth in the extractive industry, there was a significant deterioration in the situation of the population and business, not related to the extraction of natural gas. In addition, a flourishing mining/extractive industry caused an overflow of investment and labor, which limited the resources of the manufacturing industry, in which stagnation arose.

The economic model of the “Dutch disease” itself was developed in 1982 by Australian economist Warner Max Corden and his Irish counterpart Peter Neary. According to this model, the economy is divided into three sectors:

·        the non-tradable goods and services sector, that is, goods and services that cannot be moved between countries;

·        rapidly growing sector of traded goods (usually various types of raw materials);

·        non-growing sector of traded goods (manufactured goods available for export and import)

In the event of a sharp increase in the commodity sector, it begins to take labor and financial resources from the industrial sector that is so-called “direct deindustrialization”. In addition, high incomes of people working in the extractive commodity sector increase consumption, and hence the demand for non-tradable goods and services, which causes their prices to rise and the flow of labor from industry to services (which loops in a narrow circle of the solvent population) and into the extractive industry itself. In industry, however, the effect of “indirect de-industrialization” arises. In order to understand the mechanism of the development of the “Dutch disease”, one can additionally refer to the concept of the real exchange rate as the relative price of non-exchangeable goods. The increase in export revenues because of shock in the extractive sector of the economy leads to an additional inflow of foreign currency into the country. As a result, at the first stage, the nominal rate of the national currency rises, while that of the foreign one falls. Thus, the real exchange rate is growing, which means the strengthening of the national currency. In addition, a sharp increase in income creates additional demand for both exchanged and non-exchangeable goods. Since the exchangeable goods participate in international competition, their domestic price is assumed to be fixed at the world level (provided that the country is small comparing to the world economy, but there is no such condition in countries with a large extractive sector of the economy). Therefore, the additional demand does not affect the price of goods exchanged. However, the price of non-exchangeable goods is determined by the equilibrium in the domestic market (the classical equality of supply and demand). Therefore, a sharp increase in demand for them leads to higher prices. The result of these processes is to turn deflation into inflation and further strengthen the real exchange rate. Further, according to the classical scheme - The real appreciation of the national currency reduces the competitiveness of domestic products in general, which entails a number of negative consequences. In particular, the output and exports of the processing industries are reduced, which can lead to an increase in unemployment, imports increase, net exports decrease and, ultimately, gross domestic product. In the long term, the “Dutch disease” leads to the transfer of resources from the manufacturing sector to the extractive sector, which creates a smaller amount of added value, but until a certain time guarantees a high turnover of the funds invested there. In addition, the long-term dependence of the economy on the export of natural resources weakens incentives for the development of the manufacturing industries and the creation of new technologies, inhibits interest in innovations and eventually even hits the sector of various services. The technical progress, and not the accumulation of production factors, is the source of long-term growth, is ignored a priori. The result of the “Dutch disease” is the rapid growth of only the extractive sector and the services sector (associated with this sector and consumers from there) against the background of stagnation or decline in production in the manufacturing sector and the services sector associated with it. The effect is exacerbated by the growth of the real exchange rate of the national currency and, as a result, the price increase that is uncontrolled. If the “Dutch disease” lasts long enough, the local manufacturing industry loses its competitiveness in the global market, and the country begins to lag significantly behind the global trend in industrial development. Finally, when raw materials end or their prices fall, the country finds itself in a difficult economic situation, since, apart from the extractive industry, there are no more drivers in such an economy that consistently create greater competitive added value for guaranteed economic growth.

Who is affected?

"Dutch disease" are subject to countries of different levels of development, with different types of natural resources, different social systems and worldviews. However, due to the peculiarities of the modern world economy, most often the phenomena attributed by economists to the symptoms of the “Dutch disease” occur after the start of active development of oil or gas fields. Among the developed countries affected by the "Dutch disease", one can name the United Kingdom of Great Britain. After the discovery and start of large-scale oil field development in the North Sea, the country turned from an oil importer into an exporter, as a result of which it received an inflow of foreign currency. From the summer of 1977 to the end of 1980, the British pound rose from 1.7 to 2.4 dollars. The unemployment rate over the same period, however, increased from 5.5% to 8.5%. At the same time, the number of jobs in the processing industry has declined even more. Industrial exports of the Kingdom in 1983 were at the same level as in 1976, while industrial imports grew by an astronomical 63%. Among economists, there is a point of view according to which the phenomena in the British economy in the late 1970s - early 1980s are partially or fully explained by the global crisis and the policies of the Cabinet of Margaret Thatcher. However, in the work of K. Alec Chrystal “Dutch Disease or Monetarist Medicine? The British Economy under Mrs. Thatcher” is shown that the outpacing growth in oil production, which began in 1977, led to negative consequences for the British manufacturing/processing industry. In addition, this effect was swift and uncontrolled, with which the Cabinet Thatcher also fought. However, oil or gas is not always guilty for the “Dutch disease”. Agriculture and a certain boom in the cultivation and raw material exports of a certain sort of product can also provoke this negative effect on national economies. The classic examples of the “Dutch disease”, which was caused not by the discovery of oil and gas deposits, but by other reasons, include the coffee boom in Colombia in the second half of the 70s of the last century. By the mid-1970s, 45% of Colombia’s export earnings were coffee. In 1975-1976, because of crop failures in Brazil and earthquakes in Guatemala, coffee prices increased five times. Colombian manufacturers increased deliveries, as a result of which the country's export revenues increased significantly. However, this led to the strengthening of the national currency by 20% for the years 1975-1980, which had a negative impact on the export of other products and positively on the import of goods. Also at this time, there was a rapid growth in the non-tradable sector (construction, services). The following countries were suffering from the “Dutch disease” or its individual manifestations: Australia — an increase in the extraction of mineral raw materials (iron ore, etc.) in the 2000s; Azerbaijan - oil boom in the 2000s; Indonesia - oil boom in the 1970s; New Zealand - an increase in milk production in the 2000s; Russia - oil and gas boom in the 2000s; Sri Lanka, Indonesia and Thailand - a boom in the construction industry and related sectors after the 2004 tsunami, which was caused by an influx of foreign humanitarian aid. The last case is not typical for the classics of the Dutch disease at all, but the results are similar, which shows the depth of the problems in general export and import balance within the national economic systems.

The study of resource-dependent economies can be scaled to any volume, depending on which resources to include in it, which historical period to consider, and which aspect to study. However, today, in the twilight of an almost 20-year period of abnormally high hydrocarbon prices, it would be logical to confine ourselves to countries that have experienced hydrocarbon dependence at the beginning of the 21st century and assess the degree of success of their experience in diversifying the economy. Therefore, we consider several examples below, both of the positive treatment of symptoms in the economy and of the negative outcomes. But it is important for all of us to understand one thing: Abnormal incomes from the export of mineral resources, as well as an excess of such a resource within the country, give rise to a deformation of the economy in all cases, regardless of the political system and economic policy. Achieving economic diversification in oil-exporting countries is challenging. The diversification strategies implemented in most of them were not successful. In fact, there are no examples of countries that have been able to successfully diversify the economy, freeing themselves from oil dependence, especially in cases where oil production, even against the background of falling prices, allowed the economy to remain structured without social upheavals. The success or failure of diversification depends more on implementation, appropriate economic system policy, than on other circumstances. Nevertheless, many oil-exporting countries show varying degrees of success in diversifying their economies. The better the state possesses the system management tool, the more painlessly it can be cured of the Dutch effect, but, where the temptation of easy and fast incomes prevails over the logic of economic prosperity, there is undoubtedly Dutch disease.

 Russian Federation

The economy of this country is highly affected by the risk of Dutch disease, which at any time can get out of control of the Government, especially since in the historical past the USSR suffered from this economic virus. The “Dutch disease” is a reality for Russia, because a very significant structural bias between the extractive industry and other sectors of the economy is clearly visible. However, for political reasons, many trying to ignore this danger. The authorities claim that the economy of the Russian Federation is in a stable position, there is no dependence on oil, but the foreign press, and experts see the situation differently. The real starting point is the 70s of the 20th century, when the USSR government in its foreign economic policy began to focus on the export of oil and natural gas, in exchange for products manufactured in other countries. A distinctive feature of the USSR was that the government did not attempt to reduce its dependence on oil exports. This happened for various reasons. The Western press cites several historical factors confirming the constant influence of the “Dutch disease” on the Russian economy:

1.     In the 70s of the 20th century, the USSR government adopted a focus on oil and gas exports in foreign economic policy. At that time, these actions proved to be justified: the average annual world price of Brent crude oil by 1980 increased almost 8 times. But by 1984 prices had fallen by 40%, and by 1986 by 71%, which was one of the reasons for the deep crisis, from which the USSR could not get out

2.     The reforms related to trade liberalization carried out after 1991 led to the fact that a large number of Russian enterprises were uncompetitive, as they were moved from the non-tradable sector to the traded one. The output of engineering products decreased by 64% from 1991 to 1994, food by 47%, light/textile by 89%. The output of the oil industry fell by only 32%, and gas by 12%, which ensured an increase in the share of products of these sectors in GDP

3.     In 1998, the country suffered a financial and economic crisis, one of the reasons for which was the fall in oil prices. From the same period begins a time of rapid growth of GDP. With the beginning of the active development of industry in Russia, given its previous years of decline, the export orientation of the country all the same only intensified, and with the rapid growth of GDP, the main role is played by another increase in oil prices (1998 - $ 12.28; 2000 - $ 27.6; 2002 - $ 24.36; 2005 - $ 50.64, 2012 - $ 140)

It can be concluded that, despite the growth of GDP indicators, the country's economic development remains fake apparent, and the growth of GDP itself simply always depends on the rise in oil prices. To cure the “Dutch disease” in Russia with only a narrow range of measures, such as accumulating funds in gold reserves, creating a Stabilization Fund or protectionist policies, is impossible, because this requires a complete restructuring of the entire national economy. For the successful development of Russia, it is necessary to apply a complex method, which is currently impossible because of international sanctions against Russia. But at the same time, ironically, it is due to international sanctions that partially limit the effect of the Dutch disease, since it is this external cause that is not pushing the Government, but the economic sector and small and medium businesses to diversify and stimulate domestic production of goods and services imported, actually implementing import substitution. In Russia today in this aspect is nonsense. Favorable social environment, stimulating business activity of citizens and interest in diversification, is caused not by the system administration of the Government to minimize the impact of the Dutch disease, but by international sanctions that have blocked import access to the Russian market.

But this situation is temporary, sooner or later, anyway, dependence on the export of oil and gas, and not on the export of an intellectual and innovative product, the continuation of sanctions and political isolation can repeat the Dutch disease in the Russian economy. In systemic way, in Russia (as in all countries of the former USSR) is still in superficial and ineffective way are trying to solve the issue of human capital (science, education, creative industry, art, innovation), which plays a huge role in creating large value added products and services that may be required on foreign markets. Such products and services are still in low demand in the domestic market, which is a problem. In the economic sphere (not only Russia), one should always stimulate the development of the traded sector with the whole set of measures available to the government by investing in knowledge-intensive and high-tech industries. Even the work of the Stabilization Fund — which task of minimizing the Dutch disease in Russia is puzzling. The government invests a significant part of the Stabilization Fund in the securities of developed countries and Western banks. With this, it is most likely to be insured, considering that the Fund’s money should be kept, if not too profitable, but reliable. At the same time, no cent from the fund goes to infrastructure projects, and the development of local business projects. Due to the corruption component, the idea of using the funds of the Stabilization Fund following the example of the European Structural Funds is ignored. Although there is an opposite opinion that the funds of the Stabilization Fund helped to contain the inflation of the crisis of 2008–2009. But at the same time, the problem is not solved globally and is ignored, which is a risk.

Norway

Norway is the largest Western European producer of oil and gas, and this circumstance, in addition to fabulous incomes, for 50 years since the discovery of oil fields has remained the same headache of the Norwegian authorities. Norway is regularly taken as an example to other states: the country has achieved tremendous economic growth thanks to oil exports, effectively managing its own natural resources and the profits earned. Norway at the time of the discovery of oil reserves in 1969 did not have the technology, knowledge and specialists for independent development of fields. Foreign players entered the commodity market of this country, which dealt with key issues in which Norway was not competent enough at that time. The state acted only as a beneficiary, receiving revenues from the development of extraction industry. However, the competent policy of Norway allowed integrating and adapting citizens who worked in other areas into oil production, create related industries and become an exporter of technologies developed by it. Norway has come a long way from another gas station to an exporter of technology and professional knowledge in this area, and the creation of its own reserve fund and competent money management, which were used to develop other sectors of the economy, helped the state to avoid the symptoms of the Dutch disease. The effect of the state spending of Norway was prevented by the creation of the world's largest national welfare fund - the State Oil Fund, which is replenished with super-profits from the export of the resource. Over the 20 years of its existence, the fund’s assets have already exceeded a trillion dollars. The fund is almost inviolable - most of the funds it receives are invested in international assets and projects, and in local innovation and infrastructure projects, which has turned the fund into one of the largest shareholders with shares in more than nine thousand companies around the world. Only 3% of the fund’s money goes to government spending — only income from investments is allowed to be spent. Everything else is planned to leave future generations. One of the main reasons why the country avoided the “Dutch disease” was in time measures to level the effect of spending. By not allowing the services sector to grow excessively against the background of the oil boom, the state took advantage of the increased productivity of labor in the extraction of resources. This led to the emergence of related industries (mineral exploration, transportation, mining innovation) and, in general, increased labor productivity in all sectors of the economy, which allowed the country to diversify its own economy, becoming not only a supplier of hydrocarbons to the European market, but also an exporter of accumulated knowledge and technology. In addition, in order to avoid dizziness from success and the effect of spending, the Norwegian authorities are keeping the oil industry in tight gauntlets - the corporate tax in the country is 23%, for oil industry, the so-called special tax in the amount of 55% of income is added to it. Thus, the marginal rate in the oil sector can reach 78%. As a result, Norway has become a classical state of neo-socialism, which maximally reveals human potential, for example, health care costs in the country - one of the highest in the world - more than six thousand dollars per person per year. A similar situation is observed in the field of education and in other social segments of state interest. The main thing in this success is the state system control and responsibility to the danger.

Venezuela

Here we have a completely different example of negative influence and the inability of the system solution of the problem by the state due to internal insolvency and external pressure. The cause of the economic crisis in Venezuela is not war or cataclysms. Venezuela itself is guilty for its troubles. In the middle of the last century, Venezuela was the country with the highest standard of life in Latin America, second only to the USA, Switzerland and New Zealand in terms of GDP. The country was an example of democracy for all of Latin America. Now it has become an impoverished dictatorship. Nevertheless, we are not about politics, although it is not here without it. Venezuela is now passing through the stage when the veil of sweet socialism was gone with the wind, revealing the gigantic problems in which the country was embroiled by the regime of Hugo Chávez and Nicholas Maduro who replaced him. Oil-rich Venezuela — 16% of the world's reserves — is unable to pay its debt obligations. Oil accounts for 90% of Venezuelan exports - the main source of budget revenues in the country since 1935. There is no industry in Venezuela - it imports almost everything: from toilet paper to bread and medicines. All the troubles of Venezuela, oddly enough, began because of the oil discovered in 1914. During this period, the government was content enough with royalties. However, already in the 50s, oil producing companies had to pay half of their income to the budget, in the 70s - 55%. At the same time, there was a sharp jump in oil prices and the subsequent nationalization of the extraction/mining industries. Based on local oil assets, the government creates the corporation Petróleos de Venezuela (PDVSA) and begins experiments with subsidizing the national economy with oil money. Together with the inflation of the state public sector and the growth of its wages, industry and agriculture have declined. The lack of qualified specialists in all branches of government been replaced by the foreign citizens. Nevertheless, in the period of the 70s-80s, Venezuela was considered the richest country in Latin America, since any product could be purchased for petrodollars. If the Venezuelan did not have money, they could receive them in exchange for political loyalty. This practice became widespread in 1999, after Hugo Chávez came to power with his program of "Bolivarian socialism."

In 2000, when oil prices rose sharply, Venezuela literally bathed in petrodollars. However, in 2012, when prices began to fall, cash flow began to dry up. The government headed by Nicolas Maduro had to make a difficult step: to allow the national currency, the Bolivar, to weaken. Prices for imported goods would still rise due to a lack of dollars. But rising prices would lower the rating of the new government, and the president in particular. To maintain its popularity, the president has kept the exchange rate too overvalued and tightened control over imports and access to currency. After imports collapsed, prices began to rise. The government tried to control prices, and as a result, goods went to the black market. In addition, financial problems have been added to all this, as oil revenues have been halved, and the budget deficit has grown. Here again it was necessary to take an unpopular decision - to cut costs and increase taxes. For the newly elected president, this was akin to sentencing. Instead, Venezuela turned on the printing national currency press, and soon hyperinflation was added to economic problems. The standard of living and incomes of the population have grown; the president has achieved results, but only temporarily. The real culprit of all the problems of the current Venezuela is the so-called Chavism. This political movement is a mixture of socialism, left-wing radicalism and populism, the green movement, patriotism and internationalism at the same time. The political course of Hugo Chávez and Nicolas Maduro is called "Socialism of the XXI century". If we discard political declarations, then its elements on the basis are corruption, incompetent management, a complete lack of understanding of the mechanisms of economic development. There is no doubt that the international sanctions policy initiated by the United States, Great Britain and the EU in retaliation for the harsh nationalization of the oil industry and the losses incurred by Trans National companies is the revenge of ‘’bad’’ capitalism, however, no one wanted to suffer grievances and losses. That is, the crisis in Venezuela is the result of the chronic deterioration of the economic struggle over the years against the Dutch disease, the mediocre social policy of the state that wasted on the super-profits from petrodollars, international sanctions caused to crush the anti-capitalist regime in the country with the largest global oil reserves. From 2000 to 2017, in Venezuela, government spending in relation to GDP rose from 28% to 60% - much more than in other Latin American countries. These expenses gradually depleted foreign exchange reserves. Chávez, in his barbaric economic management, squandered the oil wealth that financed Venezuelan socialism. His attacks on private business left the country without experienced specialists and capital for further development. In recent years, Venezuela has produced less oil than China, and only a quarter of the production of the UAE. Moreover, this country is again with the largest oil reserves in the world. The result was a default in 2017 and a vague outlook for 2019.

How to resist?

First of all, the “Dutch disease” occurs in countries with hypertrophied raw materials exports (and raw materials are not always natural resources, but also some kind of unique product even from the agricultural sector), when the extraction/mining industry stifles other industries, and income growth leads to higher local currency exchange rate. Accordingly, at the state level, the struggle against this phenomenon can develop in three directions:

·        by limiting revenue growth in the extraction sector

·        stimulating the development of the manufacturing industry

·        elimination of super profits from consumption

Restricting/limiting the incomes of extraction industries is the most common way to deal with the “Dutch disease”. It consists in blocking super-profits of the extraction industry through extremely high taxation or their direct withdrawal by the state. The meaning of this method of “treatment” is that if the extractive sector of the economy is deprived of super-profits, it loses advantages over the manufacturing sector and does not create pressure on the labor market, consumer prices, or the national currency rate. In this case, a necessary condition for blocking “extra” revenues is their withdrawal by the state abroad in the form of creating special sovereign funds (“future generations funds”, stabilization funds, etc.), whose money are invested in foreign/national assets and projects. When the situation in the commodity markets deteriorates, the money of these funds can be used domestically to mitigate the negative social consequences of a reduction in the incomes of the commodity sector. In poor developing countries, the creation of such funds encounters resistance from the population: it is difficult for people to understand why withdrawing money from a country if it does not solve social problems or the majority of the population lives extremely poorly. At the same time, due to the low level of economic education of people and their natural desire to improve living conditions, the arguments about the negative long-term consequences of waste of natural raw materials do not meet with the population expectations. Nevertheless, such funds exist in both developed and third world countries. Extra-profits of the extraction industry can also be seized not by force, but through stimulation of savings activity of the population and business. However, such measures are complex, not always successful and unpredictable in consequences. The third way to “treat” the “Dutch disease” is protectionist measures to support the industry, including subsidizing the production of export products and tariff policies. Such measures are potentially dangerous, since the industry eventually gets used to state support and, when the situation with the export of raw materials changes, is unable to act in open market conditions. Higher import tariffs lead to higher domestic prices and market distortions. Moreover, if a country is a member of international trade organizations and customs unions, the introduction of higher tariffs is difficult and can lead to retaliatory measures by other states. A less disruptive way to support industry is government investment in education and infrastructure. Such investments can increase the competitiveness of domestic production on a long-term basis, diversifying the labor and services market. However, the effect of such measures is not immediately apparent, and their effectiveness may be low due to corruption and an incorrect assessment of business needs by the state. Again, it all depends on government management and compliance policies. Therefore, to quickly cope with the Dutch disease and rent-oriented behavior will not work. Simple recipes are not here.

What can be said in conclusion? The discovery of a large oil/gas field or other raw materials reminds of winning the lottery - the country receives tremendous wealth. However, quoting Miguel de Cervantes: “The gratification of wealth is not found in mere possession or in lavish expenditure, but in its wise application” remains still actual!

Sergiy Golubyev (Сергей Голубев)

EU structural funds, ICO projects, NGO & investment projects, project management, comprehensive support of business