Oil Dutch Disease

seDraft Chapter for: Managing Volatility and Crises A Practitioner’s Guide March 2004

Managing Oil Booms and Busts in Developing Countries
by Julia Devlin and Michael Lewin∗ Peer Reviewers: Nina Todorova Budina (World Bank) and Rolando Ossowski (IMF)

ABSTRACT The poor economic performance of oil rich countries has led to the notion that oil abundance, ideally a blessing, is frequently a“resource curse” which stunts instead of spurring economic growth. Explanations for this phenomenon can be divided into two categories. The first emphasizes governance issues (including rent-seeking and corruption); the second emphasizes the economic effects, often called “the Dutch disease.” This study examines the latter set of issues in oil-exporting developing economies, with an emphasis on therole of fiscal policy. It surveys policies and institutional mechanisms designed to minimize the harmful effects of oil booms and busts through government expenditure management, selfinsurance, and asset diversification.

Managing Volatility and Crises Managing Oil Booms and Busts in Developing Countries________________________________________________________________________________________________________

Resource Abundance: the Paradox of Plenty? The weak economic performance and continued poverty of many commodity-dependent economies, particularly oil-exporting ones, continues to pose a challenge to development economists. That resource-poor countries have outperformed resource-rich countries in terms of economic growth has been well documented (see Ranis 1991; Sachs and Warner1995; Auty 2001).1 The explanations for poor growth performance on the part of oil-exporting countries can be roughly divided into two categories. Some focus on governance issues such as corruption, rent-seeking, and bloated public sectors (Karl 1997; Eifert, Gelb, and Tallroth 2003). Others focus on the economic effects: namely, the Dutch Disease and volatility (Gelb and Associates 1988; Corden andNeary 1992; Aizenmann and Marion 1993; Gavin 1997; Hausmann and Rigobon 2003). This study focuses on the latter set of issues. As such, it addresses two main areas: understanding the macroeconomic effects of oil dependence in the developing country context; and surveying policies and institutional mechanisms to manage oil booms and busts through expenditure restraint, self-insurance, and assetdiversification---also in the developing country context. A strong and transparent public governance climate is an essential underpinning for such management. The Economic Effects of Oil Revenues Much of the analytical framework for the Dutch disease argument was anticipated in the debate in the 1920s over German reparations, which became known as the “transfer problem.”2 Among other things, it wasargued that a country receiving reparations payments (a transfer) could be worse-off in the long run as a result. This seemingly paradoxical outcome can occur, it was argued, because in the absence of other capital flows, the receiving country must run a trade deficit to accommodate the transfer (and vice versa for the transferring country.) As an integral part of this process, it will undergo anappreciation of the real exchange rate so that net exports can decline. Exports will fall and imports will rise, the trade deficit being financed by the transfer. Disposable income and consumption in the receiving country will have risen so that the country becomes better off (and vice versa for the payer.) Over the years, however, economists have noted that the fall in exports due to the realappreciation could have deleterious effects beyond the immediate disruption to the sector. In particular, if the transfer is short-lived, then the rise in income and consumption could also be short-lived. However, the decline of the traditional export sector may be difficult to reverse. In contemporary terminology this is sometimes called “de-industrialization.” Proponents of this view note that...