Economic Research Forum (ERF)

Dutch disease, developing oil-exporting countries and Iraq’s exchange rate

1872
It is sometimes suggested that the Iraqi economy is similar to that of the Netherlands after the discovery of extensive reserves of natural resources: suffering from an overvalued currency that depresses exports and economic activity in other sectors – what is known as ‘Dutch disease’. This column argues that such analysis does not apply to Iraq – or indeed to the economies of any of the world’s developing oil-exporting countries – and leads to erroneous conclusions about the country’s exchange rate.

In a nutshell

To suggest that the Iraqi economy suffers from Dutch disease is an inaccurate prognosis of its illness, and inaccurate prognosis of an illness produces an inaccurate prescription for its remedy.

Erroneous identification of Iraq’s development problems with Dutch disease typically leads to an equally erroneous conclusion that the price of the Iraqi dinar in US dollars is overstated.

In fact, Iraq’s economic reality means that it is high time now to adjust the dinar’s exchange rate vis-à-vis the US dollar upwards.

The phenomenon of ‘Dutch disease’ describes what happens to an advanced industrial economy when it receives massive earnings of foreign exchange from exporting newly found natural resources, such as gas. When the Netherlands received the revenues from exporting gas, it had a mature economy with well-developed non-gas economic sectors. Exports of non-gas tradable sectors (agriculture and manufacturing) were dominant in the country’s trade. The share of non-gas exports represented about 75% of the GDP.

Moreover, the economy was regulated by market forces, which determined movements of production factors across economic sectors. And economic rates, including the interest rate, the profit rate, the wage rate and the exchange rate, were stabilised around comparable rates in the international market. These rates governed the sectoral composition of the economy by affecting movement of resources between the sectors. The short-run impact of the earnings from gas exports, with labour being the only mobile factor, was to create a spending effect and a resource movement effect.

The revenues from the gas export destabilised the internal rate of interest and the exchange rate of the national currency. The former declined below the rate in the international market, and the latter increased sharply. These two changes led to destabilising the state of equilibrium in the Dutch economy. This in turn released forces, both on the supply side and demand side, which together created the conditions for the emergence of Dutch disease in the economy.

On the supply side, as the expanding gas sector was offering a comparatively higher wages to attract qualified workers; it attracted labour away from non-gas and conventional export sectors. With the economy operating at close to the state of equilibrium, and in order to keep workers in the non-gas tradable and non-gas export sectors, wages had to be raised in these sectors.

But these wage increases were not accompanied by improvements in productivity. They, therefore, increased the unit cost of goods and services in the non-gas sectors, which in turn raised the price of Dutch non-gas exports in the international market and rendered them less competitive.

Meanwhile, and with its ease of access to (gas) funds, the Dutch government was increasing public spending without raising taxes. This expansion gave rise to a higher household income and private expenditure, and raised the internal demand for goods and services in the economy. As a result, the demand for non-tradable activities (transport, services and utilities), as well as for goods destined for exports, increased, causing a further rise in the price of Dutch goods destined for the international market.

At the same time, and thanks to abundant revenues from gas exports, Dutch producers were borrowing money at an artificially low interest rate. They were not, therefore, under any pressure to improve factor productivity to maintain profit, or match the productivity performance of their international competitors.

In addition to all of these factors, which made the cost and price of supply of Dutch exports comparatively higher in the international market, there were also forces at work on the demand side that were pushing the price of Dutch non-gas exports up even further. The influx of revenues from gas exports was raising the demand for Dutch currency substantially, and this was raising its exchange rate vis-à-vis foreign currencies. The Dutch currency was becoming more expensive for foreigners to buy to pay for Dutch non-gas exports.

In other words, Dutch exports were increasingly pricing themselves out of the international market. This combination of factors led to a contraction in the share of Dutch non-gas exports and a loss of its non-gas export markets to its competitors. The share of Dutch non-gas tradable goods sectors in GDP was shrinking. In other words, the influx of earnings from gas exports was pushing the Dutch economy towards de-industrialisation and de-agriculturalisation – the phenomenon that became known as Dutch disease.

None of this analysis applies to the Iraqi economy – or indeed to the economies of any of the developing oil-exporting countries in the world. The Iraqi economy does not have (and never had) dominant non-oil export sectors (be it industry or agriculture).

Moreover, because it is a developing economy, neither its sectoral composition nor use of its production factors are at, or close, to the state of equilibrium. In other words, production sectors can be expanded and the use of production factors can be increased without running into the problems described for the Dutch economy. As for the economic rates in the Iraqi economy, they are largely determined by government policies and not by market forces.

Perhaps the only common characteristic that the Iraqi economy may share with Dutch disease is the relatively ‘high’ exchange rate of its currency, supported by substantial dollar earnings from the export of oil. But to say that the Iraqi economy suffers from Dutch disease because of the high exchange rate of its national currency is like saying all surgical operations in medicine are the same because they use anaesthetic.

To suggest, therefore, that the Iraqi economy suffers from Dutch disease is an inaccurate prognosis of its illness, and inaccurate prognosis of an illness produces an inaccurate prescription for its remedy.

Those who have erroneously identified Iraq’s development problems with Dutch disease, typically, also, come out with an equally erroneous conclusion that the price of the Iraqi dinar in US dollars is overstated. This conclusion disregards the fact that the current exchange rate of the Iraqi dinar against the US dollar was set by the International Monetary Fund when the Iraqi economy was suffering from the following three major problems:

  • An astronomic foreign debt left over from the previous regime.
  • Low levels of international foreign currency reserve.
  • And a low level of oil production and exports in the period 2003-06 (the time when the current dinar/dollar rate was set).

Now, and many years after the exchange rate of the dinar was set, significant developments have taken place in the Iraqi economy. Its foreign debt has been substantially reduced, its foreign currency reserves have increased appreciably, and its oil production and exports have markedly improved.

The exchange rate that was determined for the Iraqi dinar, therefore, did not (and still does not) accurately reflect Iraq’s economic reality. This rate served (and still does) no one but the interest of foreign countries. Therefore, it is high time now to adjust the dinar’s exchange rate vis-à-vis the US dollar upwards.

 

Tags: , , , ,

Most read

Trust in Lebanon’s public institutions: a challenge for the new leadership

Lebanon’s new leadership confronts daunting economic challenges amid geopolitical tensions across the wider region. As this column explains, understanding what has happened over the past decade to citizens’ trust in key public institutions – parliament, the government and the armed forces – will be a crucial part of the policy response.

Growth in the Middle East and North Africa

What is the economic outlook for the Middle East and North Africa? How is the current conflict centred in Gaza affecting economies in the region? What are the potential long-term effects of conflict on development? And which strategies can MENA countries adopt to accelerate economic growth? This column outlines the findings in the World Bank’s latest half-yearly MENA Economic Update, which answers these questions and more.

Climate change: a growing threat to sustainable development in Tunisia

Tunisia’s vulnerability to extreme weather events is intensifying, placing immense pressure on vital sectors such as agriculture, energy and water resources, exacerbating inequalities and hindering social progress. This column explores the economic impacts of climate change on the country, its implications for achieving the sustainable development goals, and the urgent need for adaptive strategies and policy interventions.

Assessing Jordan’s progress on the sustainable development goals

Global, regional and national assessments of countries’ progress towards reaching the sustainable development goals do not always tell the same story. This column examines the case of Jordan, which is among the world’s leaders in statistical performance on the SDGs.

Small businesses in the Great Lockdown: lessons for crisis management

Understanding big economic shocks like Covid-19 and how firms respond to them is crucial for mitigating their negative effects and accelerating the post-crisis recovery. This column reports evidence on how small and medium-sized enterprises in Tunisia’s formal business sector adapted to the pandemic and the lockdown – and draws policy lessons for when the next crisis hits.

Unleashing the potential of Egyptian exports for sustainable development

Despite several waves of trade liberalisation, Egypt’s integration in the world economy has remained modest. In addition, the structure of its exports has not changed and remains largely dominated by traditional products. This column argues that the government should develop a new export strategy that is forward-looking by taking account not only of the country’s comparative advantage, but also how global demand evolves. The strategy should also be more inclusive and more supportive of sustainable development.

The threat of cybercrime in MENA economies

The MENA region’s increasing access to digital information and internet usage has led to an explosion in e-commerce and widespread interest in cryptocurrencies. At the same time, cybercrime, which includes hacking, malware, online fraud and harassment, has spread across digital networks. This column outlines the challenges.

Rising influence: women’s empowerment within Arab households

In 2016 and again in 2022, a reliable poll of public opinion in the Arab world asked respondents in seven countries whether they agreed with the statement that ‘a man should have final say in all decisions concerning the family’. As this column reports, the changing balance of responses between the two surveys gives an indication of whether there been progress in the distribution of decision-making within households towards greater empowerment of women.

Macroeconomic policy-making for sustainable development in Egypt

In recent years, economic policy in Egypt has been focused primarily on macroeconomic stabilisation to curb inflation, to reduce the fiscal deficit and the current account deficit, and to increase GDP growth. As this column explains, this has come at the expense of the country’s progress on the Sustainable Development Goals, which is rather modest compared with other economies in the region or at the same income level. Sustainable development needs to be more integrated with the conception and implementation of fiscal and monetary policies.

Economic consequences of the 2003 Bam earthquake in Iran

Over the decades, Iran has faced numerous devastating natural disasters, including the deadly 2003 Bam earthquake. This column reports evidence on the unexpected economic boost in Bam County and its neighbours after the disaster – the result of a variety of factors, including national and international aid, political mobilisation and the region’s cultural significance. Using data on the intensity of night-time lights in a geographical area, the research reveals how disaster recovery may lead to a surprising economic rebound.