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POVERTY
THE WORLD BANK REDUCTION
AND ECONOMIC
MANAGEMENT
NETWORK (PREM)

Economic Premise
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JUNE 2010 • Number 16

54867
Dealing with Dutch Disease
Milan Brahmbhatt, Otaviano Canuto, and Ekaterina Vostroknutova1

This note looks at so-called Dutch disease, a phenomenon reflecting changes in the structure of production in the
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wake of a favorable shock (such as a large natural resource discovery, a rise in the international price of an
exportable commodity, or the presence of sustained aid or capital inflows). Where the natural resources discovered
are oil or minerals, a contraction or stagnation of manufacturing and agriculture could accompany the positive
effects of the shock, according to the theory. The note considers channels through which such natural resource wealth
can affect the economy. It also focuses on the development implications of Dutch disease, particularly the potential
negative effects related to productivity dynamics and volatility; and concludes with a summary of possible policy
responses, including the mix of fiscal, exchange rate, and structural reform policies.

The recent boom in primary commodity prices has once such as increasing returns to scale, learning by doing, or pos-
more stimulated interest in the issue of “Dutch disease.” This itive technological externalities. Concerns about Dutch dis-
term refers to changes in the structure of production that ease may also arise in the context of large, sustained private
are predicted to occur in the wake of a favorable shock, such capital or foreign aid inflows (Auty 2001).
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as discovery of a large natural resource or a rise in the inter- This note lays out a basic model of Dutch disease, follow-
national price of an exportable commodity that is perceived ing Corden and Neary (1982), and considers channels
to be permanent. Such structural changes are expected to through which natural resource wealth can affect the econ-
include, in particular, a contraction or stagnation of other omy; it focuses on the development implications of Dutch
tradable sectors of the economy; and to be accompanied by disease, particularly the potential negative effects related to
an appreciation of the country’s real exchange rate (Gelb productivity dynamics and volatility; and it concludes with
and Associates 1988). Where the booming sector is oil or a summary of possible policy responses, including the mix
minerals, the declining tradable sectors would include man- of fiscal, exchange rate, and structural reform policies.
ufacturing and agriculture, according to the theory. In prin-
ciple, such changes in the structure of production should be A Model of Dutch Disease
welfare improving, reflecting changes in demand associated
with an improvement in national income. They may, how- When studying Dutch disease, researchers typically model
ever, be a matter of concern for policy makers if the declin- the economy as consisting of three sectors: the natural re-
ing sectors are thought to have some special characteristics source sector, the nonresource tradables sector (usually un-
that would stimulate growth and welfare in the long term— derstood as agriculture and manufacturing), and the

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nontradables sector (including nontradable services and con- more open to capital flows and in relatively less capital-in-
struction), as presented in Corden and Neary (1982). The tensive manufacturing sectors, consistent with the theoreti-
prices for both the natural resource and nonresource trad- cal model developed in the study.
ables sectors are set in the world market, and those in the One of the measurement issues with Dutch disease is the
nontradables sector are set in the domestic economy. The difficulty in finding the counterfactual size of the tradables
real exchange rate is defined as the price of nontradables rel- sector—that is, determining how large the tradables sector
ative to the price of tradables. There generally are two types would have been in the absence of the natural resources. We
of effects leading to Dutch disease and real exchange rate use the Chenery and Syrquin (1975) norms approach to es-
appreciation: timate a norm for the size of the tradables (manufacturing
1. The spending effect comes into play when increased do- and agriculture) sector by country income group over time.
mestic income from the booming natural resource sec- Figure 2 shows the difference between the actual size of the
tor leads to higher aggregate demand and spending by tradables sector and the Chenery-Syrquin norm. For the
the public and private sectors. Increased demand for
nontradables leads to higher prices and output in the
nontradables sector. Wages in the economy will tend Figure 1. Terms-of-Trade Shocks and Real Appreciation, 2004–08
to rise, squeezing profits in the nonresource tradables
sector (“manufacturing”), where prices are fixed at in- 0.6
ternational levels.
2. The resource movement effect takes place when a boom
0.4

change in log of REER

in the natural resource sector attracts capital and labor
from other parts of the economy. It tends to reduce
0.2
output in the rest of the economy. In particular, re-
duced output in the nontradables sector causes the
price of nontradables to rise relative to the price of 0
–0.4 –0.2 0 0.2 0.4 0.6 0.8 1.0
tradables, which are set in the world market. This ef-
fect in less likely in low-income economies, where –0.2
most inputs used in the natural resource “enclave” are
imported from abroad. –0.4
Both effects result in a fall in the output share of nonre-
change in log of terms of trade
source tradables relative to nontradables, and a real exchange
rate appreciation—that is, a rise in the price of nontradables Source: Authors’ calculations, using the International Monetary Fund’s
relative to that of tradables. Information Notice System.
What about empirical evidence? There is relatively robust Note: REER = real effective exchange rate; y = 0.3825x + 0.0481; R 2 =
0.2364.
evidence that terms-of-trade increases cause real apprecia-
tion in natural-resource-rich countries (for example, see
Spatafora and Warner [1995]). Figure 1 displays changes in Figure 2. Dutch Disease Measure for Resource-Rich and Other
real effective exchange rates compared with terms-of-trade Countries, 1975–2005
changes, and it reveals a correlation during the recent
episode of high commodity prices. 0.05
The evidence on the shrinking of the manufacturing sec-
0
tor in response to terms-of-trade shocks and real apprecia-
percent of GDP

tion has been somewhat mixed (Sala-i-Martin and –0.05

Subramanian 2003). Recently, though, much stronger evi-
–0.10
dence of Dutch disease is presented by Ismail (2010), who
studies the impact of oil price shocks using detailed, disag- –0.15
gregated sectoral data for manufacturing and allowing for
the possibility that the extent of Dutch disease will depend –0.20
75
77
79
81
83
85
87
89
91
93
95
97
99
01
03
05

on the capital intensity of the manufacturing sector and the

19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20

economy’s openness to capital flows. Ismail finds that, in year

general, a 10.0 percent increase in an oil windfall is associ-
resource rich other
ated with a 3.4 percent fall in value added across manufac-
turing sectors. Such effects are larger in economies that are Source: Authors’ calculations, based on Chenery and Syrquin (1975).

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purpose of this figure, resource-rich countries are defined as Figure 3. Manufacturing Growth and Resource Exports, Selected
those in which the resource sector produces more than 30 Economies
percent of GDP. On average, the tradables sector in such

log of growth of manufacturing

exports x initial share in 1970
HKG
countries is lower than the norm by approximately 15 per- TAI SGP BEL
cent of GDP. NLD
IRL MYS
JPN PRT CAN
FRA BHR
HTI TUN ISL
Development Implications of Dutch Disease USA
MUS OMN
IND
MEX
PRY QAT
In general, an increase in wealth resulting from the discovery VEN
SAU

of a natural resource or a permanent rise in the terms of KWT

GHA LBY
trade is a positive development: it leads to a new equilibrium
with higher incomes and higher consumption of both non- log of natural resources exports as a share of GDP in 1970
tradables and tradables (the latter supplied to a greater ex-
tent than before through imports). Moreover, rents from Source: Sachs and Warner 2001.
mineral resources collected by government can provide re- Note: y = 0.74x – 7.49; R 2 = 0.26.
sources for investment in public goods and other develop-
ment expenditures that would have been unaffordable in
different circumstances. Analyzing the historical develop- GDP in a cross-section of countries during 1970–90 was as-
ment of several European countries and the United States, sociated with reduced manufactured export growth (figure
Gelb and Associates (1988) conclude that “there is evidence 3) and with as much as 0.4–0.7 percentage points lower an-
that, at least in some cases, high-rent activities. . . have pro- nual per capita growth in GDP.
vided an important stimulus to growth” (see also the histor- On the other hand, Lederman and Maloney (2007) chal-
ical review in Lederman and Maloney [2008]). lenge the robustness of these findings on a number of
There is, however, a long tradition of economic research grounds, including the econometric drawbacks associated
arguing that these obvious gains may have come at the ex- with the use of cross-section data and the need for a measure
pense of growth in the long term, based on the idea that of natural resource abundance better grounded in economic
manufacturing and other nonresource tradables possess spe- theory. Using panel data and measuring resource abundance
cific long-term, growth-enhancing qualities (such as the as net exports of natural resources per worker, they find nat-
presence of positive technological spillovers, learning by ural resource abundance to have a positive effect on growth.
doing effects, or increasing returns to scale in production). They also argue that productivity growth in services or the
Other considerations relate to resource depletion and em- natural resource sector may not be inferior to that in man-
ployment. Given increasing returns and costly, time-con- ufacturing, and they question whether manufacturing really
suming learning in manufacturing, the economy would possesses such special characteristics. “If the natural resource
struggle to rebuild sources of growth upon depletion of its sector is not inferior in terms of its growth potential, then
natural resource. Also, if Dutch disease affects labor-intensive this sectoral shift would be of similar import to the canonical
industries more than capital-intensive ones and increases displacement of agriculture by manufacturing. . . .”
capital intensity in general—as found by Ismail (2010)—it
could increase unemployment as it did originally in the Exchange Rate Overvaluation and Growth
Netherlands and the United Kingdom In principle, the real exchange rate appreciation that is a part
Research on these questions typically has not attempted of Dutch disease is an equilibrium phenomenon that reflects
to directly demonstrate the presence of spillovers or other a change in underlying fundamentals. However, to the ex-
growth-enhancing qualities in the tradables sector that tends tent that the real exchange rate overshoots and becomes
to decline as a result of Dutch disease. The evidence is gen- overvalued—for example, if agents mistakenly overestimate
erally more indirect, and a number of threads can be distin- the permanence of a terms-of-trade improvement—research
guished. on the relationship of overvaluation and growth is also rel-
evant. Empirical evidence on this issue generally suggests
Natural Resource Abundance and Growth that substantial exchange rate overvaluation has a strong
The influential studies by Sachs and Warner (1995, 2001) negative impact on growth. Perhaps among the most care-
are representative of a stream of literature that finds that fully designed and well-known of these studies is that of
natural resource abundance has a strong negative impact on Aguirre and Calderón (2005). Other studies include those
growth. In particular, they show that an increase of 10 per- of Williamson (2008); Razin and Collins (1999); and Prasad,
centage points in the ratio of natural resource exports to Rajan, and Subramanian (2006).

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Volatility as a Transmission Channel of natural resources or a natural resource boom might induce
Dutch disease may result in high export concentration in a deterioration in governance, for example, by stimulating
commodities that have exhibited statistically higher price greater corruption or by provoking powerful interest groups
volatility than that of manufacturing products (Jacks, to engage in more intense political or bureaucratic battles
O’Rourke, and Williamson 2009). Natural resource prices for control and redistribution of natural resource rents, lead-
and revenues tend to be volatile because of the low short- ing even to armed conflict or civil war. Tornell and Lane
term supply elasticity of natural resource output. If govern- (1999), for example, model a “voracity effect” in which a
ment spending is closely related to natural resource terms-of-trade improvement leads to lower growth by pro-
revenues, it also will become more volatile. Spending volatil- voking a struggle between powerful groups, leading to an in-
ity, in turn, will drive volatility in the real exchange rate crease in unproductive fiscal redistribution that is more than
(through the spending effect described above). A large body proportional. As large increases in spendable revenues divert
of empirical work documents the adverse impact of eco- production and the focus of bureaucrats away from the pro-
nomic volatility on investment and growth. Among other ductive activities, revenues from rents could lead to a de-
types of volatility, that in real exchange rates is often found tachment of the governments from their tax bases, like in
to have an especially clear adverse impact on economic per- “rentier” states (Levi 1988).
formance. Loayza et al. (2007) provide a recent survey. Ser- The panel data study by Collier and Goderis (2007), how-
ven (2003) documents the impact of real exchange rate ever, does not find statistically significant evidence that nat-
volatility on investment. Van der Ploeg and Poelhekke ural resources directly worsen governance or institutional
(2009) also show that economic growth declines with the quality, although it does find evidence that the quality of ex-
volatility of unanticipated output growth. isting institutions conditions the quality of economic policies
that countries use to deal with natural resource abundance—
Overborrowing that is, with how natural resources affect growth. Mehlum,
High commodity prices in the 1970s encouraged many re- Moene, and Torvik (2006) suggest that, in countries with
source-abundant countries to use their resources as collateral “grabber-friendly” institutions, a natural resource boom will
to borrow abroad to finance large investment projects and lead to a shift out of productive activity into unproductive
high public consumption. When prices plunged in the rent seeking. In countries with “producer-friendly” institu-
1980s, these countries were left with balance-of-payments tions, on the other hand, a natural resource boom attracts re-
crises and unsustainable external debt levels (Manzano and sources to move into productive activity. In the empirical
Rigobon 2007). A recent paper by Reinhart and Rogoff part of their study Mehlum, Moene, and Torvik find that the
(2010) suggests that when external debt rises above 60 per- negative impact of natural resources on growth steadily falls
cent of GDP, annual growth declines on average by 2 per- as institutional quality increases. When institutional quality
cent; and for high levels of debt, growth is cut in half. is sufficiently high, the natural resource effect becomes pos-
itive. Robinson, Torvik, and Verdier (2006) develop a model,
Reconciling the Evidence: The Importance of Governance in countries with weak institutional controls on the use of
and Policies clientelism and patronage to influence elections, where a nat-
Recent work attempts to reconcile the somewhat disparate ural resource boom creates incentives for politicians to use
evidence on the relationship, if any, between natural re- revenues on expanded public sector spending and employ-
source abundance and growth—particularly between cross- ment to improve their chances of staying in power.
section results that find strong evidence of a natural resource Excessive public spending appears to be at the heart of
curse and time series studies that find primary commodity economic mismanagement in the wake of natural resource
booms to be generally positive for growth. Collier and booms. The following section looks at this and other policy
Goderis (2007) adopt a panel cointegration methodology considerations that have been found useful to control the
that enables them to disentangle the short- and long-term potential negative impacts from Dutch disease.
effects of commodity prices on growth, looking at 130 coun-
tries during 1963–2003. They find that commodity price Policy Responses
booms do have positive short-term impacts on growth, but
that the impacts are significantly negative in the long term. The actual impacts of natural resources on an economy will
However, these negative long-term effects exist only for depend to a large extent on policies.
“point source” natural resources like oil and minerals, and
only in countries with bad governance. Fiscal Policy
The literature suggests that natural resource riches create Highlighting the role of fiscal policy in the natural resource
or exacerbate institutional weaknesses. First, the discovery boom episodes in the 1970s and 1980s, Gelb and Associates

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(1988) conclude that “the most important recommendation net future revenues from these resources; and then calculat-
to emerge from this study is that spending levels should have ing the constant real amount (or annuity) that, received for-
been adjusted to sharp rises in income levels more cautiously ever, would yield the same net present value. The permanent
than they actually were.” Fiscal policy is the main instrument income approach then recommends restricting government
for dealing with the negative impacts of Dutch disease for spending from these exhaustible natural resource revenues
the following reasons: it is a tool that can make the increase to only this constant annuity amount, while saving the rest
in wealth permanent, it can constrain the spending effect abroad. Later, when exhaustible natural resources have run
(the main channel of negative impacts transmission in low- out, the government would be able to draw on its accumu-
income countries), and it can smooth expenditures to re- lated financial assets to continue spending the same constant
duce volatility. annuity amount.
There is empirical evidence that government spending is Whereas saving most of the revenues in order to smooth
correlated with the increases in resource revenues. (For ex- consumption may be part of the development strategy in
ample, see Katz et al. [2004] for the case of African countries.) some countries, the development needs may be too great in
Saving revenue proceeds abroad and reducing aggregate other (especially, low-income) countries. Collier et al.
spending will help if the spending effect is believed to be (2009) argue that directing all resource revenues to current
one of the main transmission channels. Smoothing spending consumption is wasteful and inequitable; however, postpon-
over time also would help reduce volatility and its harmful ing the consumption into the far-distant future is wasteful
impacts on the economy. and inequitable as well. They suggest an “optimal” fiscal rule
The smoothing of spending is achieved through a detach- for a developing country. This rule would make it possible to
ment of spending from the resource revenues, and the in- save some of the revenues (less at the beginning and more
troduction of fiscal rules for how much of the resource at the end of the high-resource-revenues period) and allow
revenues can be spent and how much saved in a natural re- for more investment and consumption from the resource
source fund (see Davis, Ossowski, and Fedilino [2003]). The revenues than in the permanent income strategy. Perfect im-
use of a medium-term expenditure framework was found plementation of this approach would require strict fiscal dis-
useful for successful implementation of fiscal policy in re- cipline and clear spending rules.
source-rich countries.
Much has been written on the best institutional arrange- Spending and Structural Policies
ments to govern nonrenewable natural resource revenues Spending policies also can help curb Dutch disease. Direct-
(see Barnett and Ossowski [2002] for a review). Although ing spending toward tradables (including imports) rather
adequate revenue management does not always require set- than nontradables would help slow the impacts through the
ting up a special fund, an increasing number of countries spending effect. Improving the quality of spending to ensure
have institutionalized fiscal rules to express their preferences that productivity in nontradable sectors increases alongside
over management of the resource revenues by creating an the structural changes also would be important. If the spend-
explicit natural resources fund, with strict rules governing ing effect works also through private spending, general poli-
payments into and out of the fund. Depending on the pur- cies toward improving productivity of the private firms
pose of the fund (reducing volatility, constraining the spend- would help reduce the impacts.
ing effect, or investing in future growth), a stabilization fund, Policies that encourage demand for imports—for exam-
savings fund, or investment fund can be created. Incorporat- ple, trade liberalization—would help reduce demand pres-
ing the natural resources fund into the general budgetary sure on the nontradables sector and, therefore, may be part
system helps in making decisions on striking a balance be- of the structural policy response to Dutch disease.
tween dealing with the impacts of Dutch disease and pur- To the extent that the country continues to experience
suing development objectives. A fund—however simple and some real exchange rate appreciation and other adverse ef-
transparent—cannot resolve complex fiscal policy issues by fects of rising natural resource revenues, there may be a case
itself; it can only aid in implementing an already sound fiscal for orienting spending especially to investments that would
policy. help enhance productivity in the nontradables sector of the
An adequate fiscal policy would be balanced between the economy—such as investments in transport and logistics in-
need to implement development objectives and the need to frastructure, expanded investment in education and skills
constrain the spending effect. A fiscal rule called the “per- training to foster faster absorption of foreign technology and
manent income approach” provides an important bench- innovation, and so on. Building rural roads is usually one of
mark for fiscal policy (van Wijnbergen 2008). Applied only the most powerful poverty-reducing investments, and it
to exhaustible resources, this approach recommends first could involve more local labor. However, special care needs
calculating the expected net present value of all expected to be taken to ensure that there is adequate capacity to pri-

5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise

oritize and implement public projects, especially in low- in- Auty, R. M., ed. 2001. Resource Abundance and Economic Development. Ox-
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Barnett, S., and R. Ossowski. 2002. “Operational Aspects of Fiscal Policy in
The country also may undertake other reforms that do
Oil-Producing Countries.” Working Paper 02/177. International Mone-
not necessarily involve large expenditures, but that enhance tary Fund, Washington, DC.
economywide productivity: improvements in business reg- Budina, N., G. Pang, and S. van Wijnbergen. 2007. “Nigeria’s Growth
ulations, reductions in red tape, reduction of monopolistic Record: Dutch Disease or Debt Overhang.” Policy Research Working
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geting has been an extremely successful instrument, although ural Resources Curse: Reconciling a Conundrum.” Working Paper 276.
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Collier, P., and A. Hoeffler. 2009. “Testing the Neocon Agenda: Democracy
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Corden, W. M., and P. J. Neary. 1982. “Booming Sector and Deindustrial-
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Note Gelb, A., and Associates. 1988. Oil Windfalls: Blessing or Curse? Washington,
DC: World Bank.
1. The authors would like to thank Manu Sharma for his Giavazzi, F., J. R. Sheen, and C. Wyplosz. 1988. “The Real Exchange Rate
excellent research assistance. and the Fiscal Aspects of a Natural Resource Discovery.” Oxford Eco-
nomic Papers 40 (3): 427–50.
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About the Authors ‘Resource Curse’: Theory and Policy Implications.” Working Paper 9424.
National Bureau of Economic Research, Cambridge, MA.
Milan Brahmbhatt is economic adviser, Poverty Reduction and Ismail, K. 2010. “The Structural Manifestation of the ‘Dutch Disease’: The
Economic Management (PREM) Network, World Bank. Ota- Case of Oil Exporting Countries.” Working Paper 10/103. International
viano Canuto is vice president, PREM. Ekaterina Vostroknu- Monetary Fund, Washington, DC.
Jacks, D. S., K. H. O’Rourke, and J. G. Williamson. 2009. “Commodity Price
tova is senior economist, East Asia and Pacific Poverty Reduction
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