Summary:
– Like the Gulf countries, the abundance of raw materials provides fertile ground on which economies can base their development processes. However, it is not easy to capitalize on these riches. The disastrous management of Dutch gas in the late 1970s is the best-known example of this.
– For more than 40 years, many countries have in turn experienced significant impoverishment, mainly caused by their overabundance of natural resources. However, some countries have, on the contrary, managed to enrich themselves thanks to their incredible reserves.
– Several studies show that the main reasons for this dichotomy among these « well-born » countries are differences in net savings rates and institutional quality.
– Finally, even if the causes of this phenomenon seem to have been identified, recent developments in certain emerging countries such as Brazil indicate that this paradoxical phenomenon of impoverishment is still very much alive.
The « curse of natural resources, » the « Dutch disease, » and « the paradox of plenty » are all nicknames given to this situationin which acountry rich in natural resources tends to become poorer. However, the most commonly used term remains Dutch Disease, in reference to the experience of the Netherlands in the 1970s, which was the first country to experience a sudden increase in raw material wealth followed by a sharp contraction in economic activity.
However, it would be simplistic to believe that an economy relatively well endowed with natural resources is inevitably doomed to decline. Indeed, for every example of a country that has become impoverished due to its abundance of raw materials (Democratic Republic of Congo, Venezuela, Algeria, Nigeria, etc.), there is a counterexample of a country that has succeeded in becoming remarkably wealthy thanks to these resources (Norway, Qatar, Australia, United States). It is therefore necessary to reframe the discussion around this phenomenon, no longer limiting the analysis to the single question of « Why do countries rich in natural resources become impoverished? », but rather extending it to » Why do some countries succeed in capitalizing on these riches more than others? » After a brief historical and theoretical overview of how this mechanism works, we will attempt to outline the various factors that influence the beneficial impact of abundant natural resources on economic development. Finally, we will see that although it is relatively old and often characterized as « old fashioned, » the » Dutch Disease threat » regularly returns to the forefront and remains more relevant than ever in certain emerging countries (Brazil).
Dutch Disease, a story that smelled of gas.
This paradoxical phenomenon of impoverishment caused by an abundance of natural resources first appeared in the Netherlands in the late 1970s. In summary, the history of Dutch Disease unfolded in four phases:
– Following the discovery of large gas deposits, the flat country significantly increased its national gas supply. Once the domestic market was saturated, Dutch producers dumped their production on international markets. The global demand response was immediate and led to a sharp appreciation of the national currency (the guilder) within a few months (as international buyers demanded more Dutch currency to purchase this gas).
– The Dutch guilder, stronger than ever, significantly increased the international purchasing power of the local population, which increased its import volumes. Combined with the decline in the competitiveness of Dutch exports (excluding gas), this increase in demand for foreign goods precipitated a trade deficit, as gas exports could not offset this double negative impact of the exchange rate (increase in imports, decline in the competitiveness of non-gas exports).
– Domestically, the increase in gas production had other adverse effects. The rise in household purchasing power resulting from the appreciation of the guilder and the revenues generated by the gas industry pushed up the general price level. Inflation thus further weakened exporting companies, which, in addition to an unfavorable exchange rate, had to cope with higher input costs.
– Finally, the gas sector became the most profitable industry in the country (as its marginal productivity was higher than that of other sectors, it offered higher wages). This led to a massive migration of labor from struggling industries (mainly exporters) to the gas industry. In addition, companies that were losing competitiveness and seeing their employees « flee » began to offer higher wages, which fueled inflation. Ultimately, the gas sector became the most important in the country and, in the late 1970s and early 1980s, accounted for the majority of foreign and domestic investment.
The flight of labor from non-gas industries ultimately completely disrupted the Dutch productive fabric. Once the expanding sector was saturated with this labor (energy-type industries being relatively capital-intensive, labor needs were quickly met), unemployment skyrocketed. Underlying inflation and expansionary fiscal policies aimed at maintaining the purchasing power of the Dutch population both contributed to an increase in imports and a widening of the trade deficit (as well as a deterioration in the budget balance). As a result, the Netherlands entered recession only a few years after discovering its abundant gas reserves. This phenomenon was described in 1977 by The Economist and given the name Dutch Disease for the first time .
From Practice to Theory
Following the emergence of Dutch Disease and its spread to other countries, economists proposed several models and theoretical frameworks aimed at isolating the mechanisms of this phenomenon. However, the best-known model to date remains that of Corden (1982). The analytical framework he proposes presents an economy composed of three sectors (the expanding sector, the lagging sector producing tradable goods, and the non-tradable goods sector). The two effects defined by Corden as the main mechanisms of Dutch Disease are the reallocation and expenditure effects. The reallocation effect, as explained above, represents the transfer or migration of labor from backward sectors producing non-tradable goods to the natural resource sector (which is expanding). This effect thus illustrates the destructuring of the industrial fabric and the concentration of labor within the expanding sector. The second effect, known as the « expenditure effect, » defines the transfer of labor from the lagging sector to the non-tradable goods sector. Indeed, following the increase in wage income in the booming sector, the demand for non-tradable goods (i.e., domestic goods such as services) rises sharply, fueling inflation and the demand for labor in this sector. Corden’s model thus exposes us to these two migratory effects, which ultimately tend to « destroy » the industrial sector (which is lagging behind).
However, even though this model explains the fundamental mechanisms of Dutch Disease, some authors such as Rybcynski (Rybcynski’s Theorem – 1955) and Bhagwati (Theory of Impoverishing Growth – 1958) had already laid the foundations for growth models in which an exogenous shock to a factor of production (such as the discovery of natural resources) tended to reduce the total level of production in the economy.
What are the differences between examples and counterexamples of Dutch Disease?
The benefits that countries can derive from their abundant natural resources are manifold and widely recognized. In simple and intuitive terms, the exploitation of these resources generates significant export revenues when the country decides to sell its production on international markets (sales proceeds and export taxes). For some countries, these export revenues are considerable and can, in some cases, reach more than 35% of GDP (Angola, Nigeria). However, this dependence on export revenues exposes the countries concerned to the risks of price fluctuations on international markets and further accentuates the fragility of their economies. It is also important to note that the natural resource sectors, particularly the energy sector, are not very job-intensive and are often considered enclaves incapable of driving national growth. The use and management of the income generated by these natural resources therefore becomes crucial to the economic success of these countries. If effectively reallocated, these revenues can contribute to the « endogenous » development of the domestic economy by promoting the accumulation of factors necessary for this process, such as human and physical capital.
Nevertheless, many of these countries rich in « raw materials » fail to capitalize on their wealth and suffer from the perverse mechanisms of Dutch Disease described above. Why? The differences observed between countries « cursed » and « blessed » with natural resources provide some answers.
- Saving income from the exploitation of natural resources
A paper by Ragnar Tovrik (2009) shows that countries that have managed to avoid Dutch Disease have higher savings rates (net, i.e., taking into account the loss of natural wealth caused by extraction) than countries that have not managed to escape this curse. According to this study, countries that save more of their income from natural resource exploitation would therefore avoid the Dutch Disease phenomenon. Without seeing a direct cause-and-effect relationship, it is likely that countries that do not immediately « squander » these sources of income are more inclined to allocate these revenues to productive and growth-accelerating uses. Consequently, it would be interesting to consider the timing of the use of these raw material export revenues or their forms of savings as indicators of good natural resource management.
- The quality of institutions
The quality of institutions is undoubtedly a determining factor in the occurrence of Dutch Disease. In countries where institutions are considered » predatory, » natural resources and the revenues they generate are more likely to be expropriated and monopolized by elites and others who control the country’s official structures. Indeed, institutions of poor quality that do not provide effective protection of property rights, do not limit the power of elites or other pressure groups, and do not promote equal opportunities, are more likely to encourage rent-seeking or « predatory » behavior, whose primary purpose is not to generate productive activities and which, more often than not, leads to an increase in negative externalities. On the other hand, so-called » benevolent » and therefore high-quality institutions tend to promote the efficient and redistributive management of revenues from the exploitation of natural resources. Furthermore, by guaranteeing property rights and constraining the power of local elites, high-quality institutions limit the « evaporation » of revenues caused by rent-seeking behavior. To support this argument, several empirical studies have shown that an abundance of natural resources, when combined with high-quality institutions, has a strong positive effect on economic growth rates, thereby offsetting the expected effects of Dutch Disease.
From a more structural perspective on the organization of institutions within countries affected by Dutch Disease, an original study by Andersen and Aslaksen (2008) attempts to link this phenomenon of the natural resource curse to the existing political framework. Their work shows that countries with a parliamentary system are more likely to avoid this curse than countries with a presidential system. Although we might think that parliamentary systems encourage rent-seeking behavior among politicians and channel the returns from natural resources to a small minority, it is also likely that this type of system, unlike the presidential system, is more inclined to allocate these resources to productive uses that benefit the majority of the country, given its representativeness of the population. This argument contrasts with the rather « one-man show » nature of presidential systems, in which an individual acting « alone » would be more tempted to serve his own interests and those of his entourage.
- The type of resource and the question of the degree of resource appropriation
Finally, another determining factor in Dutch disease, closely linked to the importance of institutional quality, is the degree of appropriation of natural resources. In a country with weak institutions, the capture of these resources will be all the more widespread if the degree of appropriation (and expropriation in the case of poor institutions) of these riches is low. From a technical point of view, it seems obvious that it will be easier to « get your hands on » diamonds and other precious stones than on arable land and herds of more than 10,000 head. Thus, the degree of appropriation may also prove to be a determining factor in the occurrence of Dutch Disease and the negative effect of poor-quality institutions on natural resource management.
What strategies should countries « cursed » by their natural resources adopt?
The differences outlined above attempt to explain why some countries manage to escape the Dutch Disease trap. But these differences are structural, and the institutions that, as we have just explained, are a determining factor in the occurrence of this phenomenon, remain extremely rigid and take some time to be effectively redefined. Indeed, establishing institutions that guarantee property rights and promote efficient, fair, and redistributive management of revenues from the exploitation of national wealth takes time and depends largely on changing attitudes and the weight of tradition within communities. Nevertheless, this does not mean that the situation of resource-rich countries currently experiencing Dutch Disease -type problems cannot be improved. Numerous natural resource management policies have been implemented in countries that have succeeded in enriching themselves through these resources. The establishment of sovereign wealth funds in Norway and the Gulf countries has promoted the sound management of revenues generated by these resources, thereby effectively preserving the fruits of this energy windfall (particularly in Norway, with the sovereign wealth fund’s investments in stocks and bonds) and better diversifying the productive fabric (in the Gulf countries, with the development of research, services, etc.). Even if, in the end, the success of these sovereign wealth funds and raw material management policies is closely linked to the initial institutional quality of these countries, the establishment of such programs, coupled with a « renovation » of the institutional landscape aimed at limiting predatory behavior, would be an adequate treatment to effectively combat this Dutch disease.
An ever-present threat: the Brazilian case.
As we have just seen, natural resource management policies and the structural characteristics of economies can almost single-handedly determine the positive or negative impact that these riches will have on the economy. Some emerging and developing countries, such as Botswana, have succeeded in capitalizing on their abundance of raw materials. Nevertheless, this expansion, which is mainly based on the exploitation of primary goods and which, in some cases, can be considered « too rapid, » now raises some doubts about the sustainability of this growth and the potential negative repercussions of a Dutch Disease-type phenomenon.
Brazil is a case in point, as it has been experiencing significant growth in food and oil exports for nearly ten years. For example, exports of raw and semi-finished primary products accounted for nearly 63% of total exports in 2011, while exports of manufactured goods had fallen by more than 18 percentage points compared to their 2006 level. This concentration of exports on primary goods, coupled with an increase in capital inflows, has strengthened the real, which in turn has reduced the competitiveness of Brazilian industrial goods (such as automobiles). Brazilian industry is therefore currently experiencing a relatively significant increase in the exchange rate.
Sources: FUNCEX, Banco Central Do Brasil, BSi
Furthermore, as predicted by Dutch Disease, Brazil’s natural resources sector is becoming increasingly attractive given the high returns it generates. This phenomenon has become considerably more pronounced since 2011 and the exploitation of large oil fields discovered in late 2007 off the coast of Brazil (the increase in global food prices has also contributed to this rise). The attractiveness of sectors that make intensive use of natural resources has thus reinforced the phenomenon of production factors being captured by expanding sectors and ultimately accentuated the deindustrialization effect observed since 2010.
Sources: FUNCEX, Banco Central Do Brasil, BSi
Brazil therefore appears to be in a situation where the importance of these oil and natural resources is gradually beginning to disrupt the national productive fabric and threaten the country’s overall economic performance (the GDP growth rate for 2012 is 0.9%. It was 2.7% in 2011 and 7.5% in 2010 [WEO April 2013]). Although Brazilian institutions are « relatively good, » policymakers must resist the temptation to concentrate domestic productive forces (as well as reinvestment of export revenues) in the oil and agricultural sectors in order to avoid a Dutch-style scenario.
Sources: IBGE, BSi
Similarly, other countries remain subject to such temptations and will soon find themselves obliged to implement effective rent management and economic diversification policies in order to take advantage of the opportunities offered by their natural resources and avoid repeating the mistakes of the past. Some countries, such as Angola and its sovereign wealth fund (FSDEA), have understood this well; others « just have to » follow suit…
Bibliography
Boschini D., Pettersson J., Roine J. (2003). Resource curse or not: A question of appropriability. SSE/EFI Working Paper Series in Economics and Finance, No. 534.
Torvik R. (2009). Why do some resource-abundant countries succeed while others do not? Oxford Review of Economic Policy, Volume 25, Number 2, 2009, pp.241-256.
Melhum H., Moene K., Torvik R. (2005). Cursed by resources or institutions?
Andersen J., Aslaksen S. (2008). Constitutions and the resource curse. Journal of Development Economics. Volume 87, Issue 2, Pages 227-246.
Blanco Mendoza H., Zabludovsky Kuper J., Garcia Rocha A., Lora S.G. Brazil’s Dutch Disease and the Auto Trade War with Mexico: Stylized Facts. IQOM, Trade Intelligence.
