Domestic Economy

Dutch Disease: Curse of the Unlocked Dollars

Dutch Disease: Curse  of the Unlocked Dollars Dutch Disease: Curse  of the Unlocked Dollars

The imminent release of blocked overseas funds, thanks to the July 14 nuclear deal on the one hand and the highly probable boost in oil revenues on the other have alarmed economic experts about the incidence of yet another 'Dutch disease' in Iran's economy.

Financial Times Lexicon has defined Dutch disease as the negative impact on an economy of anything that gives rise to a sharp inflow of foreign currency, such as the discovery of large oil reserves. The foreign currency influx leads to local currency appreciation, making the country’s other products less competitive on the export market. It also leads to higher levels of cheap imports and can end in deindustrialization as industries apart from resource exploitation are moved to cheaper locations. The Financial Tribune's sister newspaper Donya-e Eghtesad recently published an insight and analysis into the negative consequences of the release of Iran’s frozen assets and the likely comeback of Dutch disease to its economy.

> Onset of the Dutch Disease

The origin of the phrase is the Dutch economic crisis of the 1960s following the decline of the manufacturing sector there after discovery of the large Groningen natural gas field in 1959. Surprisingly, this positive development had adverse effects on important sectors of the country’s economy as the Dutch guilder (the standard unit of money used in the Netherlands before the euro) became stronger, making Dutch non-oil exports more expensive and, therefore, less competitive.

In the classic economic model developed by W. Max Corden and J. Peter Neary in 1982, the economy of a country seeing a dramatic rise in revenues is divided into three sectors: the booming export sector which is the extraction of natural resources such as oil, the lagging export sector which is mostly manufacturing and agriculture sectors, both of which are tradable sectors; and the non-tradable sector, which essentially includes retail trade, the service industry, and construction. Economists show that when a country develops the Dutch disease, the traditional export sector (manufacturing and agriculture) gets dumped by the other two sectors.

> Effects of the Disease

When a country experiences a hike in revenues, income grows in the early stages as more foreign currency pours in. If the entirety of increased foreign currency is spent on imports, there will be no direct impact on the country’s money supply or demand for domestically produced goods. But if the foreign currency is converted into local currency and spent on domestic non-tradable goods, what comes next depends on whether the country’s nominal exchange rate—that is, the price of the domestic currency in terms of a key foreign currency, say dollar—is fixed by the country's central bank or is flexible.

If the exchange rate is fixed, the conversion of the foreign currency into local currency would raise the country’s money supply, and pressure from domestic demand would push up domestic prices. This would lead to an appreciation of the “real” exchange rate—which means, a dollar would buy fewer goods and services in the domestic economy than it did before. If the exchange rate is flexible, the increased supply of foreign currency would strengthen the value of the domestic currency and consequently an appreciation in the real exchange rate—in this case through a rise in the nominal exchange rate rather than a rise in domestic prices. In both cases, real exchange rate appreciation weakens the competitiveness of the country’s exports, and causes its traditional export sector to shrink, its imports to swell and finally its economic growth to decline. This entire process is called the 'spending effect'.

Resources would concurrently shift to the production of domestic commodities that are not tradable internationally such as construction and services in order to meet domestic demand, and to the booming oil sector. Both of these transfers shrink production in the now lagging traditional export sector. This is known as the 'resource movement effect'.

> Iran's Bout of Dutch Disease

The late 2000s saw Iran's economy suffer from the same condition, when the oil prices rose from $25 in 2001 to $100-odd in 2010. Despite the establishment of the Forex Reserve Fund, a major part of oil revenues was pumped into the country’s economy which resulted in an appreciation of the "real" exchange rate, increase in imports and growth of the non-tradable sector compared to the tradable sector and consequently loss of domestic competitiveness. These were all the symptoms of a Dutch disease. For instance, imports skyrocketed from $18.4 billion in 2002 to $83 billion in 2011 on the back of a 50% fall in real exchange rate from 11,000 rials per dollar in 2004 to 5,000 rials per dollar in 2010. As the economic sanctions took effect and oil revenues tumbled, the real exchange rate and inflation went into an upward spiral. The real exchange rate jumped to 10,000 rials per dollar in 2012 and the quantity of imports slipped to $59 billion in 2013 accordingly. As President Hassan Rouhani took office in the same year and the political climate of the country improved, the real exchange rate dropped to 7,300 rials per dollar in 2013 and the nominal exchange rate dropped. In addition, the sanctions years forced Iran to wean itself off an oil-dependent economy and the severe symptoms of Dutch disease began to fade away.

> Fears of Relapse

If the incumbent government follows in the footsteps of past administrations, the economy might relapse into the Dutch disease when it gets access to its frozen foreign assets and oil revenues.

The likes of Forex Reserve Fund in 2001-11 failed to cushion the impacts of windfall oil revenues which led the National Development Fund of Iran to step in. But unfortunately NDF role has been reduced to dishing out foreign currency loans. The law requires the government to deposit a part of its oil revenues into NDF on a yearly basis. Once revenues increase, NDF is equipped to free up more money to shore up the private sector by granting foreign currency loans. The whole process in turn worsens the Dutch disease in the economy. If the government does not re-define the role, structure, goals, and missions of NDF, the return of Dutch disease is inevitable.

The Central Bank of Iran can also play a pivotal role in managing the foreign currency resources. CBI can maintain the balance of the market by resisting drastic fall in the real exchange rate. Now it seems the CBI is all set to prevent the resurgence of the Dutch disease.