Reviewing the literature on “Dutch disease,” this article documents that shocks that trigger foreign exchange inflows appreciate the real exchange rate, generate factor reallocation, and reduce manufacturing output and net exports. It also finds that real exchange rate misalignment due to overvaluation and higher real exchange rate volatility reduces growth. The evidence is mixed and inconclusive on the effect of undervaluation on growth, but there is no evidence that Dutch disease reduces growth. Policy responses should aim at adequately managing the boom and the risks associated with it.
Concerns about adverse growth effects of real appreciation have been explored for many years, going back at least to the “Dutch disease” literature of the early 1980s. Dutch disease refers to the effects of discoveries or price increases of natural resources that result in real exchange rate appreciation, factor reallocation, and de-industrialization (Magud and Sosa, 2010). Similar effects may stem from other shocks entailing an increase in foreign exchange inflows, such as capital inflows, foreign aid, and remittances.
While these types of shock are in principle positive due to wealth effects, there have long been concerns among economists about the potential negative impact of Dutch disease on long-term growth (Rajan and Subramanian, 2005; Ismail, 2010). These concerns are usually based on the idea that the declining (usually manufacturing) tradable sectors possess some special characteristics (e.g., increasing returns to scale, learning by doing, spillover effects, or other positive externalities) that stimulate growth and welfare in the long term.
Motivated by the experiences of China and other east Asian countries, a new literature based on the export-led growth strategy argues that an undervalued or “competitive” real exchange rate fosters growth—the operative channel being the (manufacturing) tradable sector. In this view, while real exchange rate overvaluations hurt growth, undervaluations foster it. Another position, however, argues that any real exchange rate misalignment (either undervaluation or overvaluation) from its long-run (fundamentals-based) equilibrium lowers growth (Berg and Miao, 2010).
However, showing that Dutch disease reduces growth requires a strong assumption: that the manufacturing tradable sector is “special,” assuming the existence of learning by doing or similar externalities in this sector. Absent these assumptions, Dutch disease only depicts an equilibrium real exchange rate appreciation reflecting stronger fundamentals and de-industrialization, but need not be bad for growth.
This article examines whether the literature provides support for concerns about the potential adverse effects of Dutch disease on long-term growth. To this end, we reviewed more than 60 papers on Dutch disease and on the relationship between the real exchange rate and growth. For systematic comparisons of the papers’ results, we construct indices to evaluate their partial and overall implications. The evidence is used to analyze the policy implications of Dutch disease shocks.
We document that Dutch disease does exist. Shocks that trigger foreign exchange inflows (such as natural resource booms, surges in capital inflows, foreign aid, and remittances) appreciate the real exchange rate, generate factor reallocation, and reduce manufacturing output and net exports. However, we do not find evidence that Dutch disease reduces economic growth. We also find that real exchange rate misalignment—particularly when due to overvaluation—and higher volatility of the real exchange rate reduce growth. The evidence is mixed and inconclusive on the effect of undervaluation of the exchange rate on growth.
Most of the Dutch disease empirical literature focuses on the impact of foreign exchange inflows (natural resource booms, remittances, aid, etc.) on the real exchange rate and the tradable-nontradable resource reallocation, but does not examine the effects on long-term growth or whether the adverse effects associated with Dutch disease offset the beneficial effects of inflows. Research in this area has typically not attempted to directly demonstrate the presence of spillovers or other growth-enhancing qualities in the tradable sector. Hence, the evidence on the negative impact of Dutch disease on growth is still partial, and generally inconclusive.
Concerns about Dutch disease may also derive from the view that real exchange rate overvaluation lowers growth, a result that appears to be supported by the empirical evidence. Evidence on the positive effects that an undervalued real exchange rate may exert on growth is mixed—some studies suggest that undervaluation actually hurts growth. In any case, the real appreciation associated with Dutch disease is in principle an equilibrium phenomenon reflecting a change in underlying fundamentals and does not necessarily imply overvaluation, so it is not clear why lower growth should be an unavoidable outcome. Furthermore, Lama and Medina (2010) analyze the effects of exchange rate stabilization in the face of Dutch disease shocks and find that it reduces welfare by contributing to misallocating resources and raising economic volatility.
Therefore, even though there is some debate as to whether misalignment or overvaluation lowers growth, the channel through which Dutch disease reduces growth is not found in the literature. This is quite relevant, as it affects the economic policy discussion.
Should real exchange rate appreciation be a source of concern for policymakers? Should they act to curb Dutch disease effects? If yes, is it due to concerns about long-run growth? A given appreciation of the real exchange rate may have a differential impact on growth depending on whether it reflects an equilibrium phenomenon. If the appreciation is driven by a permanent change, then it implies an equilibrium movement, and in principle Dutch disease should not be a concern. However, the real exchange rate could overshoot and become overvalued (e.g., if agents overestimate the persistence of the shock, or an excess supply of money results from the government’s monetization of the external shock, triggering an overshooting of the price of nontradable goods). Thus, macroeconomic policy should focus on avoiding overshooting, overheating, and the surge of macroeconomic imbalances that could later become unsustainable.
It is sometimes very difficult for policymakers to assess if a certain shock and the corresponding real exchange rate appreciation is temporary or permanent. If the authorities treat a permanent shock as temporary and decide, for example, to intervene in the foreign exchange market, they will delay an unavoidable—and desirable—macroeconomic adjustment, incurring as well substantial quasi-fiscal costs due to sterilization. If, on the contrary, they treat a temporary shock as permanent, they may experience costs in terms of reduced growth. The optimal policy response would depend, to some extent, on the type of shock behind the Dutch disease. For instance, in the case of a surge in aid inflows, creating a sovereign wealth fund to be held abroad would not help.
Fiscal policy is a natural instrument to help curb Dutch disease effects. In fact, excessive public spending has been a common component of economic mismanagement of booms stemming from positive Dutch disease shocks. Fiscal policy may contribute not only by mitigating the “spending effect” associated with Dutch disease, but also by smoothing expenditures to reduce output volatility. A prudent expenditure policy would help save part of the increased revenues, which could be used to either repay external debt or accumulate foreign assets. This would help to limit aggregate demand pressures and hence the spending effect, and weaken real appreciation pressures. Directing spending to tradables (e.g., imported capital goods) would also help curbing the negative impacts of Dutch disease.
If there is a presumption that the shock may be temporary, smoothing expenditure over time would help reduce volatility. In this case, a fiscal rule and a stabilization fund could be appropriate. Also, there is a case for improving the quality of expenditures, such as by promoting investments that would entail positive supply-side effects. Investments that foster productivity and the supply of nontradables (e.g., investments in infrastructure and education) would be particularly advantageous. Finally, improving financial regulation and supervision could play an important role in helping to contain credit booms or assets bubbles, reducing the likelihood of boom-bust cycles.
Therefore, should policymakers worry about real exchange rate appreciation and limit it to avoid potential Dutch disease symptoms? The evidence on the impact of Dutch disease effects on growth is mainly inconclusive. Moreover, it is worth noting that shocks that cause Dutch disease—such as large capital inflows and export price booms—are usually associated with periods of economic bonanza. Dutch disease effects are an unintended consequence of foreign exchange abundance, but these negative effects would not necessarily offset the beneficial effects of the inflow. The challenge for policymakers is to adequately manage the boom and the risks that come with them—taking advantage of the boom while dealing with the undesired consequences that it may cause. In responding to the effects of Dutch disease and thinking about how to address them, policymakers should be careful not to kill the goose that laid the golden egg.
Berg, A, and Y. Miao, 2010, “The Real Exchange Rate and Growth Revisited: The Washington Consensus Strikes Back?” IMF Working Paper 10/58 (Washington: International Monetary Fund).
Ismail, K., 2010, “The Structural Manifestation of ‘the Dutch Disease’: The Case of Oil Exporting Countries,” IMF Working Paper 10/103 (Washington: International Monetary Fund).
Lama, R., and J.P. Medina, 2010, “Is Exchange Rate Stabilization an Appropriate Cure for the Dutch Disease?” IMF Working Paper 10/182 (Washington: International Monetary Fund).
Magud, N., and S. Sosa, 2010, “When and Why Worry About Real Exchange Rate Appreciation? The Missing Link between Dutch Disease and Growth,” IMF Working Paper 10/271 (Washington: International Monetary Fund).
Rajan, R., and A. Subramanian, 2005, “What Undermines Aid’s Impact on Growth?” IMF Working Paper 05/126 (Washington: International Monetary Fund).