- Dutch Disease refers to the phenomenon wherein countries that are rich in natural resources witness uneven growth across sectors. When resource-rich countries export their resources to the rest of the world, it causes the exchange rate of their currency to appreciate significantly. This, in turn, affects other sectors in the country by discouraging their exports while encouraging the import of cheaper alternatives.
Negative Implications of Dutch Disease in an economy:
- It is thought to be transmitted primarily via exchange rate movements, following a large inflow of foreign currency.
- As foreign currency is changed into local currency, the money supply rises: extra domestic demand pushes up domestic prices. That results in an appreciation of the “real” exchange rate.
- A resource boom increases spending on non-tradable luxury goods and services disproportionately. With increased demand and opportunities in these sectors, workers leave other sectors like manufacturing.
- Thus, production in these sectors decline not necessarily because they are costly but because they are not a priority in the short-run.
Other side of argument:
- Losing employment isn’t a bad thing if the jobs that were lost were low-paying and the jobs that replaced them elsewhere were higher-paying and more of them.
- The gains do get passed along and not just in the one sector.
- Maybe there were fewer people employed in one sector, but employment is not the measure of the health of an industry. It’s the capacity to generate high wages and incomes.
Indian context of Dutch Disease:
The collapse in oil prices in 2014 served as a large, positive terms-of-trade shock for India.
- India witnessed large gains from the collapse in oil prices (3.1% of GDP across two years, of which two-thirds was estimated to have been spent).
- So the collapse in oil prices should have put upward pressure on actual and equilibrium real exchange rates.
- The only choice policymakers had, was whether to accommodate this real appreciation through nominal appreciation or relatively higher inflation.
- Operationally, this manifested itself in a collapse of the CAD (because of oil) and therefore a larger balance of payments surplus that was putting upward pressure on the rupee.
- This was compounded by foreign direct investment flows almost doubling after this government came to the power. All this exacerbated the rupee appreciation pressures.
- To keep the rupee from depreciating further, the shout for another large dollar loan from non-resident Indians has already started. This may see strong demand again underscoring the point that India has a liquidity problem (that is, a near-term shortage), and not a solvency problem (people do not doubt India’s ability to repay the dollars in the future).
Should we worry?
- Firstly, policymakers should not fight this real depreciation since it’s an equilibrium phenomenon, but simply use reserves to ensure the new equilibrium is reached in a gradual manner, so as to avoid self-fulfilling panic and overshooting.
- Second, there are bound to be inflationary consequences of the rupee depreciation. Under the new inflation targeting framework, this will need to be countered by monetary tightening. So, external stress will need to be buffered through a weaker currency and higher rates, as is being witnessed all around the world.
- Third, it is crucial that fiscal policy (at the Central and states) does not slip again. The more expansive the fiscal policy, the more it will offset the real depreciation that will occur from the positive terms-of-trade shock reversing, and thereby hurt the competitiveness of the tradable sector.
- Fourth, policymakers need to continue working on improving underlying trade competitiveness, apart from exchange rate, by boosting infrastructure, total factor productivity and assimilating into global value chains.
- India is much more fortified than in 2013, but that should not mask the fact that underlying, external imbalances have widened. The recent rise in crude prices and the real depreciation that it will induce may well be a blessing in disguise, because it may help improve underlying competitiveness. But the scale of what needs to be done to improve trade competitiveness, more fundamentally, remains daunting and should be underestimated only at our own peril.