Dutch Disease in Trinidad and Tobago

5 /3/2012 2:29 PM

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Dutch Disease in Trinidad and Tobago

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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 gas revenue 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), the conversion 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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Dutch Disease in Trinidad and Tobago

5 /3/2012 2:29 PM

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 from other 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. Doctor's orders What can policymakers do? Fortunately, as we have become aware of
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Dutch Disease in Trinidad and Tobago

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Doctor's orders What can policymakers do? Fortunately, as we have become aware of 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. 2012 Trinidad & Tobago Chamber of Industry and Commerce | Site by Sugar Islands Privacy Policy

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