Economic Research Forum (ERF)

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

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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.

 

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