Dutch Disease in T&T

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Dutch Disease in Trinidad and Tobago

The gratification of wealth is not found in mere possession or in lavish expenditure, but

in its wise application." Miguel de Cervantes, 16th century Spanish author.

In the sixteenth century, the Spanish colonisation of the Americas gave Spain newfound

access to gold and other natural resources, which it chose to spend mainly on war and

luxury. When the flow of gold dried up, Spain experienced a long period of decline and

was left with a heavy debt burden. Perhaps Cervantes recognised, in his own country,

symptoms of what later became known as "Dutch Disease," a term that broadly refers

to the harmful consequences of large increases in a country's income.

In the 1960s, the Netherlands experienced a vast increase in its income and wealth

after discovering large natural gas deposits in the North Sea. The substantial gasrevenue financed a sharp increase in government spending. Unexpectedly, this had

serious repercussions on important segments of the Dutch economy, as the Dutch

guilder became stronger, making Dutch non-oil exports less competitive, and leading to

a loss of jobs in these industries. This syndrome has been called "Dutch Disease."

Although the Disease is generally associated with a natural resource discovery, it can

occur from any development that results in a large inflow of foreign currency, including

a sharp surge in natural resource prices, foreign aid, and foreign direct investment.

Economists have used the Dutch Disease model to examine such episodes, including the

impact of the inflow of treasure from the Americas on Spanish industry in the 16th

century, gold discoveries in Australia in the 1850s, the coffee export boom in Colombia

in the mid-1970s, and the oil boom from 1973 to 1979.

Doctors diagnosis

Why does this dramatic increase in wealth produce an economic paradox? The answer is

found in a classic paper by Corden and Neary in 1982. These authors divide an

economy experiencing an export boom into three sectors: booming, lagging and

nontraded.

The booming and lagging sectors are the two tradable sectors, which produce goods

and services for export and domestic consumption (energy, manufacturing, and

agriculture). The non-tradable sector supplies domestic residents only and might

include retail trade, services, and construction. They show that when a country catches

Dutch Disease, this unequivocally leads to a decline in the traditional export sector.

How does this happen? Let's take the example of an energy-based country that faces a

sharp jump in oil prices. The windfall increase in oil exports initially raises incomes

through more inflows of foreign exchange. If the foreign exchange were spent entirely

on imports, it would have no direct impact on the country's money supply or demand

for domestically produced goods. But suppose the foreign currency is converted into

local currency and spent on domestic non-traded goods. What happens next depends on

whether the country's (nominal) exchange ratethat is, the price of the domestic

currency in terms of a key foreign currencyis fixed by the central bank or is flexible.

If the exchange rate is fixed (as was the case in most oil producing countries), theconversion of foreign currency into local currency would increase the country's money

supply, and pressure from domestic demand would push up domestic prices. This would

amount to an appreciation of the "real" exchange ratethat is, a unit of foreign

currency now buys fewer "real" goods and services in the domestic economy than it did

before. If the exchange rate is flexible, the increased supply of foreign currency would

drive up the value of the domestic currency, which also implies an appreciation in the

real exchange rate, in this case through a rise in the nominal exchange rate rather than

in domestic prices. In both cases, real exchange rate appreciation weakens the

competitiveness of the country's traditional export sector. The country has difficulty

exporting manufactured or agricultural goods, and domestic producers cannot compete

with an onslaught of imports.

This entire process is called the "spending effect."

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At the same time, the demand for capital and labour in the booming oil sector

increases, typically drawing resources from both agriculture and manufacturing and the

domestic non-traded sector. Both of these transfers lead to a decline in the now lagging

traditional export sector. This is known as the "resource movement effect." When

capital and labor shift from one sector to another, industries are forced to shut down

and workers have to find new jobs. This transition is painful. A shift in resources away

from manufacturing sectors that generate "learning by doing" might put at risk a

country's longterm growth potential by choking off an important source of human

capital development.

If the capital and technology used in the booming oil sector are very much

sectorspecific and the booming sector also requires no significant amount of labor fromother sectors, then there is no resource movement effect. The booming sector is

essentially an enclave, isolated from the onshore economy.

The Patient: Trinidad & Tobago

Trinidad & Tobago is the richest country in the Caribbean, with a GDP of close to

US$15,000 per person. Energy is the key economic sector, accounting for over 40% of

GDP and close to 45% of revenue in 2006.

Oil windfalls in the 1970s delivered spectacular wealth and financed much of public

expenditure, leading to the Dutch Disease. And now once again, Trinidad & Tobago is

experiencing an energy boom and is catching the Dutch Disease. A key warning sign

relates to the record levels of public spending on capital projects whose productivity is

often low. Concerns have been expressed in many quarters about excessive or

otherwise inefficient public investment projects either through political pressures to

spend rather than to save, bribery involved in obtaining lucrative government

investment contracts, or nationalistic pride in promoting a particular project (so-called

white elephants).

Although rising energy revenues have improved the governments balance sheet, an

even more rapid increase in public spending has worsened the underlying budgetary

position. Monetisation of the non-energy deficit remains the major catalyst for pushing

liquidity into the financial system. The classic result is too much money chasing too few

goods. This has placed an unfair burden on monetary management and poses a serious

risk to the control of inflation. Movements in the real effective exchange rate (REER) do

not provide clear indications of the phenomenon in Trinidad & Tobago. The REER in

2005 was about its 2001 level.

Nevertheless, Dutch Disease-like crowding out of agriculture and manufacturing is

evidenced by small shares in output and employment. Agriculture, for instance, now

contributes less than 1% to total GDP compared with 2.5% in 1982.

The contribution of manufacturing has been stagnant at 6% of GDP. Furthermore,

agriculture has lost over 11,000 jobs in 2000- 2005 while manufacturing has gained

only 1,000 jobs. As a result, the Dutch disease is helping to transform Trinidad &Tobago from Caribbean tiger to Caribbean pussycat. By 2005, the countrys global

competitiveness ranking had tumbled to 67th position from 31st position in 2001.

Another consequence of the Dutch Disease is that significant rents associated with

resource exploitation may lead to corruption. Corruption is also difficult to define or

even quantify. Organisations such as Transparency International (TI) calculate indices

measuring the perceived degree of corruption in a number of countries. In 2001,

Trinidad & Tobago scored 5.3 out of a highly clean score of 10 to rank 31 out of 91

countries on the TI Corruption Perception Index. By 2005, Trinidad & Tobagos score

had fallen to 3.8 to rank 59 out of 158 countries on the Corruption Perception Index,

suggesting that corruption has become more of an issue. In 2006 our score was

3.2,79th of 163 countries.

Resource abundance is often associated with neglect of education and health and poor

development of human capital in many countries stricken with the Dutch Disease.

Although public spending on education and health has tended to be high in Trinidad &

Tobago, attesting to the governments commitment to building human capital, results

have been disappointing. While there is near universal primary and secondary

enrollment rates, the quality of education is below world standards. Furthermore,

despite Trinidad & Tobagos high per capita income, health indicators such as life

expectancy, infant, and child mortality are not sufficiently better than the average for

the Caribbean. Poverty remains high in Trinidad & Tobago, presently estimated at 17%

of the population or over 220,000 persons.

In many respects, Trinidad & Tobago is a classic rentier state, defined as a state

reliant not only on domestic resource mobilisation, but mainly on externally generated

revenues and oil rents. In such a system, the state generates a large portion of its

wealth from extractive industries and natural resources, all sources of unearned

income, and does not develop a long-term productive outlook.

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,

the problems of the Dutch Disease, we have learned much about what can be done

about them.

Democratic, consensual and transparent processes are more likely to ensure that the

fruits of a country's wealth are equitably and well spent. In the specific case of Trinidad

& Tobago, a lot depends on whether the newfound wealth is viewed as temporary or

permanent. The government clearly views the newfound energy wealth as permanent,

using it to achieve Vision 2020 - transforming Trinidad & Tobago into a developed

society.

The focus is on expanding social services, eradicating poverty, producing a

knowledgeable workforce, enhancing environmental conditions, and raising potential

growth.

Yet policymakers need to manage the inevitable structural changes so as to ensure

economic stability. Inflation, pushed by heavy Government spending and food price

shocks, is already the major risk to macroeconomic stability. Fiscal prudence must be

the order of the day. The Government must also continue to diversify non-energy

exports to reduce dependency on the booming energy sector and make them

competitive. The 2006/2007 Budget identifies seven key sectors for industrial

development Yachting; Fish and Fish Processing; Merchant Marine; Music and

Entertainment; Film; Food and Beverages, and; Printing and Packaging.

And there remains the challenge of ensuring that the country's additional wealth is

spent wisely and managed transparently. The government intends to bring legislation to

formalise a Heritage and Stabilisation Fund (HSF). The starting balance in the HSF is

some US$1.2 billion. Subsequently, a minimum of 60% of excess oil and gas revenues

will be deposited to the Fund in each financial year. Not surprisingly, the HSF embodies

great expectations as the instrument to manage the countrys energy wealth.

However, the sobering experience with commodity stabilisation funds across the world

has shown that few have worked well and many have failed. Sound design principles

are therefore critical to helping avoid any false promises. Trinidad & Tobagos rich

endowment in energy resources can and should be a blessing, not a curse. We know

what must be done. What is missing is the political will to make it happen and to win

Cervantes approval. Trinidad and Tobag Catching the Dutch Disease.

Note: The Author wishes to credit Christine Ebrahim-zadeh, whose article Dutch

Disease: Too much wealth managed unwisely, serves as the basis for information on

the phenomenon of Dutch Disease. The article was first published in 2003 by the IMF

and does not reference the Trinidad and Tobago economy.

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