Sometimes an opportunity can become a problem without asking. Take the case of the ostrich, a bird that learned to use its legs for running around, but slowly lost its power to fly. In the context of international trade, countries sometimes face a situation called “Dutch disease”. It might sound like the problem of one particular country. But the name has nothing to do with the nationality of the problem. It could very well be an “Indian disease” or a “Chinese disease” without much difference.
Illustration: Jayachandran / Mint
Johnny: Hi Jinny. Why are you flapping your arms like the wings of a bird?
Jinny: I am conducting a new experiment. I believe that if you stop walking, then one day, you may start flying. You can also join me.
Johnny: Sorry, I have other serious issues to think about.
Jinny: Serious issues, like?
Johnny: Well, I was just wondering how a new opportunity in international trade could ultimately become a “Dutch disease”. I would be happy if you would stop flapping your arms and tell me about this.
Jinny: Oh! So that’s the serious issue you are thinking about. I could explain this in two minutes, and then you could join my experiment. The term “Dutch disease” was originally used by economists to describe a situation that arose in the Netherlands during the 1960s and 1970s. During those days, large deposits of natural gas were discovered in the Netherlands, leading to a surge in natural gas exports. Initially, the Dutch welcomed the surge of exports. Wouldn’t you be happy if you found a pot of gold in your backyard? But the Dutch euphoria was shortlived. Soon, the surge of gas exports started putting pressure on the exchange rate of the domestic currency. Higher exports led to higher inflow of foreign exchange which in turn led to the appreciation of the domestic currency. The euphoria soon turned into a tragedy. Due to the appreciation of the domestic currency, the country’s manufacturing exports lost their shine. Export of manufactured goods became uncompetitive. Exporters of traditional goods started shutting shop. So the surge of exports of natural gas became a kiss of death for the country’s manufacturing exports. The pot of gold that you discover ultimately makes you good for nothing else. This came to be known as Dutch disease.
Johnny: That was a Dutch problem. Is there an Indian version of the Dutch disease?
Jinny: Initially, the term “Dutch disease” was used to describe a situation arising out of a discovery of natural resources leading to a surge in exports, and consequent surge in foreign exchange inflows. But there is no law that says that the Dutch disease only affects you only when you discover a pot of gold. Today, this term is used in a more general sense, to describe a variety of situations that could lead to higher inflows of foreign exchange. Just look around, and you will see that we are suffering from the Dutch disease in multiple forms.
A surge in foreign institutional investor (FII) inflows in the stock market, or remittances from non-resident Indians, create the same situation in which you have to deal with the appreciation of the domestic currency. If the domestic currency appreciates, then your exports will suffer. But let the policymakers worry about that. Right now, I am more interested in resuming my flying experiment.
Johnny: Before you resume your experiment, tell me: how can policymakers deal with the Dutch disease?
Jinny: A lot depends upon whether the situation you are facing is temporary or permanent. For instance, excess FII inflows may be temporary. If the inflow is temporary, policymakers try to protect the weak sectors through foreign exchange interventions. For instance, the central bank of the country may absorb the excess inflow of foreign currency by selling the domestic currency. This would help prevent the appreciation of the domestic currency. It helps in containing the short-term fluctuations. But this cannot be a permanent solution. Overindulgence of the central bank for absorbing foreign exchange inflows, may lead to inflation. Every time the central bank purchases foreign currency, the supply of domestic currency increases. In case the inflows are of a permanent nature, you have to find a permanent solution. The economy then has to cope with structural changes so that the transition is painless. No matter what may be the cause, the final result of permanent foreign exchange inflows is always the same. Some sectors of the economy will shine while some will die.
Johnny: That’s true, Jinny. The final result of excess flapping of arms is always the same. You make your arms strong, at the cost of your legs.
What:“Dutch disease” is a term used to describe a situation in which large inflows of foreign exchange lead to loss of advantage in traditional sectors of exports.
Why: Discovery of natural resources or developments of some new sector or industry are some of the factors that may cause Dutch disease.
How: Large inflows of foreign exchange may lead to appreciation of domestic currency, making exports costlier.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org