Dutch Disease in Trinidad and Tobago 5 /3/2012 2:29 PM

Dutch Disease in Trinidad and Tobago

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Archived Magazines The gratification of wealth is not found in mere possession or in lavish expenditure, but
Translation Assistance in its wise application." Miguel de Cervantes, 16th century Spanish author.

Search 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
search 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.
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In the 1960s, the Netherlands experienced a vast increase in its income and wealth
Username:
after discovering large natural gas deposits in the North Sea. The substantial gas
Password: revenue financed a sharp increase in government spending. Unexpectedly, this had
serious repercussions on important segments of the Dutch economy, as the Dutch
login 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.

Doctor’s 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 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 (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 rate—that 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 government’s 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 country’s 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 & Tobago’s 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 government’s 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 & Tobago’s 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 5 /3/2012 2:29 PM

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 country’s 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 & Tobago’s 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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