SOURCES OF DUTCH DISEASE::

EVIDENCE FROM TRANSITION ECONOMIES, 1990-2007

Lo Bue Maria Carmela, M.A.Chair of Development Economics

Georg-Augusta Universität, GöttingenContact.: mlobue@uni-goettingen.de

EADI-DSA 2011 Conference

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Working Paper, June 2011 19 - 22 September 2011, York, UK

Outline

I. Introduction

II. Theoretical background

III. Capital inflows patterns in the EE-FSU region

IV. Empirical methodology

V. Interpretation of the results

VI. Concluding remarks

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Introduction

• During the last decade, the countries which have emerged from the former communist bloc of Eastern Europe and the former Soviet Union (EE-FSU) have all received large inflows of foreign currency, in the form of either aid, remittances, FDI, portfolio inflows or revenues from exports of oil minerals and metals .

•On one hand these currency inflows could have raised investment and encouraged economic growth.

•On the other hand, destabilizing side-effects could have been brought about by the appreciation of the Real Exchange Rate (RER) and its detrimental effects on countries competiveness. “Real Exchange Rate problem”

•“It is the possibility that capital inflows bring an appreciation of the real exchange rate with adverse effects on traded-goods production in the domestic economy” [Corden, 1994].

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Need to consider differences in the forms of inflows received, differences in the types of recipients, differences in neutralizing/alleviating options at the disposal of policy makers.

Inflows Recipients

Revenues from natural resources exports

Government - Oil companies

Aid Government

Remittances Households

FDI & Portfolio inflows

GovernmentMNCs and national enterprises Individual agents

Aim of the paper: To ascertain whether these different types of currency inflows generate a greater or smaller real exchange rate appreciation. To identify which of those is likely to affect the most the RER and-through it- the prospect for growth in the EE-FSU region4

Introduction

The Dutch Disease: one curse, different sources (A short theoretical excursus)

Most agreed definition of D.D. : reduction in a country’s export performance as a result of an appreciation of the real exchange rate after a rapid increase in the export and /or in the price of a natural resource. (“Traditional “ form of D.D.)

As depicted in Corden and Neary model (1982):Three sectors in the economy:

Booming “B” Lagging

“L”

Non – Tradable “NT”

Two effects:

Spending effect Resource movement effect

PNT /PT

Direct De-industrialization

Indirect De-industrialization

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“Non-Traditional” forms of Dutch Disease

Aid•Two Sectors : Tradable and Non Tradable•Three Effects: 1.Spending effects 2.Resource-Movement effect T NT3.Expenditure-Substitution effect 4.Destination of aid (import of capital goods, inputs; expenditure in infrastructure …)

D T TD

DN PN /PT

Remittances• Motivation: self-interested vs. altruistic purposes• Recipients’ propensity to save/consume (effects on interest rates)• Households' expenditure pattern (biased towards NT goods)

FDI & Portfolio inflow•Possible adverse effects on the Terms of Trade, Instability in the Balance of Payments and on the domestic rate of saving/ investment•Exchange rate regime and monetary policy

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Capital inflows patterns in the EE-FSU region. (A short overview)

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Net currency inflows (trend)

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Real Exchange Rate

The model

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Data: 19 EE-FSU countries; 1990-2007

Variable Name Variable Label Source Unit of measure

RER Real Exchange Rate Author’s compilation Index, 2000=100

Net

Export

Net Export of fuels, ores,

metals, precious stones and

non-monetary gold

UNCTAD Percentage of the GDP

Aid Net Official Aid/GDP DAC-OECD Percentage of the GDP

Remittances Workers’ Remittances/GDP World Bank Percentage of the GDP

FDIForeign Direct

Investment/GDPUNCTAD Percentage of the GDP

Government

Expenditure

General Government

Expenditure/GDPEBRD Percentage of the GDP

Employment

in informal sector

Share of informal sector in

total employmentILO Percentage of total employment

WTO

dummy

Dummy denoting a

year/country joining WTO

Author’s

compilation

(1=access to WTO, 0=all other

cases)

CRISIS

dummy

Dummy denoting a

country/year hit by the

Russian and Albanian financial

crisis

Author’s

compilation

(1=years of Russian and Albanian

crisis for countries identified as

Russian and Albanian main trade

partners, 0=all other cases)

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Econometric specification of the model and estimation approach

i. Linear and Non Linear effects

ii. Time Lag effects

In both cases we implement generalized least squares (GLS) serial correlation and heteroskedasticity robust method.

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Table 1: Model I , Non Linear Effects

Interpretation of the results (Table 1)

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• One point percentage of increase in remittances leads to an appreciation of 4.11% in the RER,

• One point percentage of increase in FDI leads to an appreciation of 1.78% in the RER,

• One point percentage of increase in aid leads to an appreciation of 4.9% in the RER (see col.1).

•Any significant effect of net exports of mineral resources on the dep.var.

•Effect of saving and stabilization funds,

•Increased imports (in capital goods) to enhance productivity in the oil sector,

•Extra revenues stemming from rents increased the demand for imported goods (i.e. cars, luxury goods).

•Oil price has a significant effect (but relatively small).

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Interpretation of the results (Table 1) cntd.

•Non Linearity trend for remittances and FDI.•Keep in mind that recipients in these cases are mostly private agents (household and firms)for very large inflows incentives to save/invest money and/or to increase the demand for imported goods.•Estimated turning point: 22.6 (for remittances) and 19.7 (for FDI).

•Negative effect of the abolition of trade barriersgreater incentives for the foreign counterparts to trade and relatively small incentive from the import side (limiting the outflows of money from the country).

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Interpretation of the results (Table 1) cntd.

•Negative effect of the financial crisisTrade effect (deterioration in trade exchanges after the crisis) > depreciating effect (following the removal of foreign-owned capital

•Positive effect of government expenditureincreased the volume of import. Provision of social assistance and pension funds (benefiting mostly low-income households)

•Negative effect of employment in the informal sectorexpansion of the NT sector as suggested by the “resource movement effect”

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Table 2: Model II , Lagged Effects

Interpretation of the results (Table 2)

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•Inclusion of lagged variables leads to significant and large appreciating effects on the RER.

•The results reported in columns 2 to 7, emphasize that only FDI, aid and remittances have a significant positive impact on the RER, where 1 point percentage of GDP increase in FDI, aid and remittances occurred in the previous year will lead to a 1.9%, 4.2% and 3.5%  increase in RER respectively

This results confirm our initial hypothesis on the existence of time effects (i.e. due to the limited absorbing capacity in recipient countries)

Concluding Remarks (1/4)

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Dutch Disease effects may differ among themselves because of differences in the recipients of the inflows, their average volume, destination and the ability of policy makers to moderate their effects.

For resource-endowed countries, the resource curse seemed to have been not in place (or not very important)

•Use of stabilization funds•Existence of slack in these economies and /or limited factor mobility between sectors•Use of tax windfalls to improve the competiveness of the manufacturing sector.

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Other countries (Albania, Armenia, Bulgaria, Kyrgyz Rep., Moldova, Mongolia and Tajikistan) relied on foreign aid assistance up to late 90s and on a large inflows of remittances later on.

•Difficulty in establish off-setting policies .

•“Unpopular” measures (i.e. discouraging agents to convert remittances in domestic currency, or levying taxes on remittances).

• A more feasible measure is the sterilization (i.e. the sale of State or Central Bank bonds) to drain liquidity and cushion the inflationary spiral.

Concluding Remarks (2/4)

Concluding Remarks (3/4)

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Increasing supply of foreign funds has lead to increase in the demand ( RER appreciation and high real wages).

As also noted by Grafe and Wyplosz (1997), the RER appreciation in this case could not be the result of a Balassa-Samuelson effect (given that under central planning services were very underdeveloped, productivity gains in the NT sector must have been very large).

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Concluding Remarks (4/4)

Off-setting policies in the case of FDI can be more easily implemented :

• sterilization through reinforced controls and /or taxes on capital inflows,

• intervening through the banking system (i.e. increasing the reserve requirements on banks or shifting government deposits from commercial banks to central bank).

For the prospect of future research, need to rely on more data (REER, portfolio inflows, destination of consumption) to give a more accurate explanation of the dynamics of the DD in EE-FSU transition economies.