Christine Ebrahim-zadeh of the International Monetary Fund refers to a very popular viewpoint propounded by Miguel de Cervantes Saavedra, the celebrated sixteenth-century Spanish author of Don Quixote de la Mancha. The saying goes thus: ‘the gratification of wealth is not found in mere possession or in lavish expenditure, but in its wise application.’ This view was expressed at a time when ‘Spain enjoyed new-found access to a wealth of natural resources, including gold, from the Americas.’ According to Ebrahim-zadeh, Miguel de Cervantes Saavedra did not expect his own expression to be associated, with his own country, ‘symptoms of what later became known as the “Dutch disease,” a term that generally refers to the damaging ‘consequences of large increases in a country’s income.
In the 1960s, the Netherlands experienced a vast increase in its wealth after discovering large natural gas deposits in the North Sea. Unexpectedly, this ostensibly positive development had serious consequences on important sections of the country’s economy, as the Dutch guilder became stronger, making Dutch non-oil exports less competitive. This syndrome has come to be known as the ‘Dutch disease.’ Although the disease is generally associated with a natural resource discovery, it can emanate from any development that causes a large influx of foreign currency, including a great rise in natural resource prices, foreign aid, and foreign direct investment. Economists have utilised the Dutch disease concept to analyse such events.
How does this happen especially in oil rich African states? Let’s take the example of an African country like Equatorial Guinea that discovers oil. An increase in the country’s oil exports primarily raises incomes, as there is more foreign exchange inflow. If the foreign exchange were spent completely on imports, it would have no direct consequence on Equatorial Guinea’s money supply or demand for domestically manufactured goods. But suppose the foreign currency is converted into local currency and spent on domestic non-traded goods, what happens next depends on if the country’s (nominal) exchange rate—that is, the price of the domestic currency in terms of a key foreign currency—is fixed by the central bank or is flexible.
If the exchange rate is fixed, the conversion of the foreign currency into local currency would boost the country’s money supply, and pressure from domestic demand would push up domestic prices. This would lead to an increase of the ‘real’ exchange rate—that is, a unit of foreign currency now purchases lesser ‘real’ goods and services in the domestic economy, as was the case before. If the exchange rate is flexible, the augmented supply of foreign currency would lead to an increase in the value of the domestic currency, which also implies an appreciation in the real exchange rate, in this scenario via a rise in the nominal exchange rate rather than in domestic prices. In both situations, real exchange rate appreciation lessens the competitiveness of the country’s exports and, hence, causes its traditional export sector to collapse. This whole process is referred to as the ‘spending effect’.
Simultaneously, resources, especially labour and capital, would deviated into the manufacturing of domestic non-traded goods to meet the increase in domestic demand and into the growing oil sector. Both of these transfers would reduce production in the now lagging traditional export sector. This is referred to as the ‘resource movement effect’.
It is evident that these effects which played out in the oil-rich nations in the 1970s, when oil prices soared and oil exports rose at the expense of the agricultural and manufacturing sectors, are now playing out in oil rich African states. Similarly, higher coffee prices in the late 1970s, after frost damaged Brazil’s coffee crops, led to an increase in coffee sectors in producers like Colombia at the expense of the traditional export sector as spending and resources were transferred to the non-traded goods sector. Oil rich African states have also given less importance to the agricultural sector and have concentrated on oil concessions and agreements with the West.
Is the hindrance on the lagging traded goods sector like agriculture in Africa really a problem? Some economists do not agree especially if the higher inflows are expected to be permanent. In such a situation, they say, the Dutch disease may merely indicate the economy’s adaptation to its new-found wealth, making the term ‘disease’ a misnomer. The shift in production from the tradable to the non-tradable sector is simply a self-correcting mechanism, a way for the economy to adapt to an increase in domestic demand.
But other economists argue that even a permanent change is disturbing. When capital and labour, drift from one sector to another, industries are forced to wide up and workers have to seek for new jobs. This transition—no matter how short—is painful, socially, economically and politically. Economists also worry that a drift in resources away from manufacturing sectors that promote ‘learning by doing’ might endanger a country’s long-term growth potential by choking off a vital source of human capital development. The bottom line is that, irrespective of whether these changes are seen as a problem, policymakers especially in oil rich African nations like Cameroon and Equatorial Guinea must help the economy cope with these ramifications.
A plausible solution
What can policymakers in oil rich African states do? A lot will depend on whether the new-found wealth is temporary or permanent. In African countries that expect new resource discoveries to be depleted fairly rapidly, aid flows to be temporary, and terms of trade gains to be transitory, policymakers may want to protect the vulnerable sectors—possibly via foreign exchange intervention. The sale of domestic currency in exchange for foreign currency—that is, the build-up of official foreign exchange reserves—tends to keep the foreign exchange value of the domestic currency lower than it would otherwise be, helping to insulate the economy from the short-run consequences of the Dutch disease that will soon be reversed. But there remains the challenge of ensuring that the build-up of reserves does not lead to inflation and that the country’s additional wealth is spent wisely and managed transparently via, for instance, a central bank account or a trust fund.
In African states whose new-found wealth is likely to be permanent, policymakers need to manage the inevitable structural changes in the economy so as to ensure economic stability. They may want to adopt measures to boost productivity in the non-traded goods sector (possibly via privatization and restructuring) and invest in worker retraining. They may also want to continue to diversify exports to reduce dependency on the booming sector and make them less vulnerable to external shocks, such as a sudden drop in commodity prices.
Whether exercising caution in managing new riches or changing the course of the economy to adapt to new circumstances in oil rich African states, such wise application of wealth would, indisputably, have won Cervantes’s endorsement.