Conventional wisdom suggests that prosperity and currency appreciation are good for the welfare of a nation. However, if domestic wealth increases too quickly, a phenomenon known as Dutch disease may prove detrimental to the long-term economic health of an afflicted country.
What Is Dutch Disease?
Dutch disease is a financial expression used to describe the negative influence that a sudden appreciation of a nation's wealth and domestic currency can have on its well-being. It is typically found in emerging economies dependent upon commodity production and exportation, but is also periodically recognised in developed nations.
First coined in 1977 by The Economist magazine, the phrase "Dutch disease" originally referred to the 1959 Holland natural gas find and economic woes that followed. While natural gas production initially brought great wealth to the region, problems such as high unemployment and lagging investiture eventually stifled the once-booming Dutch economy.
Although the economic situation in Holland was the first documented case of Dutch disease, it was certainly not the last. The event's underpinnings are frequently attributed to the bold appreciation of local commodities. Precious metals, energy and rare earth minerals are examples of raw materials capable of quickly generating extraordinary wealth for the country of origin. Subsequently, short-run foreign exchange rates move in favour of the domestic currency for several reasons:
In the event commodity values rise precipitously, related businesses are able to generate abnormal returns on operations. As a result, commodity-based sectors expand aggressively, temporarily boosting economic output.
Large influxes of foreign investment capital are frequently realised by nations benefiting from new resource finds or commodity price appreciation. As the perception of a regional economic boom grows internationally, swelling demand for the domestic currency drives exchange rates higher.
Increase In Aggregate Economic Growth
Both industrial expansion and foreign investiture promote economic growth. As a result, gross domestic product (GDP) is strengthened, employment moves in a positive direction and wages increase.
While the above items appear positive, they are often symptoms of Dutch disease. As industrial expansion, foreign investiture and bolstered economic growth enhance currency value, negative trends compromising domestic economic health take root.
The Negative Influence Of Wealth
A rapid boost in currency value and domestic wealth often prove to be detrimental. Accordingly, below are the two negative consequences that serve as the backbone of Dutch disease:
Stronger local currency values lead to a non-competitive export market. In essence, the cost of manufacturing goods at home is higher than that of foreign competitors abroad. In turn, the export sector underperforms due to the competitive disadvantage.
The sudden wealth appreciation associated with Dutch disease leads to greater purchasing power abroad. Subsequently, the demand for imports increases. This can be extremely negative as the expanding consumption of foreign goods places added pressure on domestic manufacturing. The results frequently turn out to be a contraction of manufacturing-based industries, growing unemployment rates and the rise of job outsourcing to other nations.
Due to economic diversification, developed nations are better equipped to deal with the negative impacts of Dutch disease than emerging ones. However, the consequences of spiking commodity prices, currency values and national wealth can negatively influence even superpowers. As an illustration, energy reliant economies such as Canada and Russia have periodically been victimised.
It is important to remember that the relevance of Dutch disease is a regularly debated topic in financial circles. Advocates claim that the sharp spike in currency value sets the stage for financial crisis and undermines any chance of long-term prosperity. Critics make the case that sustained commodity-based sectoral growth is good for the public welfare in many regions of the world.
Either way, empirical evidence shows that the rapid appreciation of domestic wealth and currency value poses a collection of foreign trade-related challenges. Ultimately, an increased demand for imports and an uncompetitive export sector are capable of hampering the future growth prospects of many international locales.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…