Dutch disease, diversification and the UAE’s dirham-dollar peg

Minimisation of the effects of oil dependency – eradication of the Dutch disease – must go hand-in-hand with careful management of the national currency, writes Frank Kane.

Do not confuse Dutch disease with Dutch elm disease. The first is a malady that can affect national economies over-reliant on one export; the latter, of course, is a malignant fungal infestation that kills elm trees.

But they are similar in two respects: both can crop up anywhere in the world, not just in Holland. And they can devastate the entity – tree or economy – in which they occur.

In the wake of falling oil prices, policymakers are waking up to the effects of over-reliance on energy exports in their national economies. From Azerbaijan to Venezuela, and many of the places in between, the economic strategists are wondering how to live in the new era of cheap oil.

The UAE has been on this path for some time. For at least the past 10 years, the need to diversify away from an oil-dependent economy has been a constant theme of government strategy. It was reinforced at the recent two-day retreat of UAE leaders in Dubai to consider the era of cheap oil, from which specific policy recommendations are imminently expected.

The country has already made big advances. In 1980, energy-related industry accounted for 80 per cent of GDP; now it is around 30 per cent. The progress has been especially fast in Dubai, where oil revenue now accounts for less than 5 per cent of economic activity, and where trade, transport, tourism and finance are now the main earners for the emirate.

But governments are still highly reliant on oil revenues to fill the public purse; about 80 per cent of the fiscal budget comes from oil earnings. How to bridge this gap when oil prices are 70 per cent lower than 18 months ago is the strategic challenge UAE leaders are facing.

It seems like homespun common sense that you should never put all your eggs in the same basket, and the concept of Dutch disease has sometimes been rendered as the “curse of oil”, but this would be to oversimplify the economic theory.

Dutch disease is actually a quite sophisticated line of argument that looks at the effect of reliance on one commodity for the foreign exchange dealings of a country.

It was first identified in Holland – hence the nickname – in the 1950s, when the country discovered significant reserves of natural gas and became an energy exporter. Economists not­iced that as energy exports soared, the currency rapidly appreciated, making other exportable Dutch products too expensive.

Non-energy exports suffered and other industries weakened, exacerbating the power of the gas industry. There are other effects too: the cost of non-exportable goods and services rises, leading to inflationary pressures; capital investment dwindles outside the energy sectors.

Holland eventually got out of its Dutch disease rut with the advent of the European Common Market, and eventually the euro. The currency effect of Dutch disease was simply abolished overnight with the disappearance of its national currency, the guilder.

This foreign exchange effect should not be underestimated. The first signs of impending trouble – the first symptoms of Dutch disease, if you like – come when a currency appears too strong in the international markets.

The Russian rouble, the Kaz­akh tenge, and the Azerbaijan manat all enjoyed long periods of strength on international markets in the first decade or so of this century. The rouble – which was not pegged to the dollar or any other currencies – crashed as the oil price decline began in 2014, and still has to find a natural floor.

Both the tenge and the manat were dollar-pegged to some degree, and when this prop was removed it led to a rapid devaluation of the currency in both cases, making management of the economy much harder to handle. Venezuela, too, faces extreme foreign exchange pressures.

The lesson seems to be that minimisation of the effects of oil dependency – eradication of the Dutch disease – must go hand-in-hand with careful management of the national currency.

Leaders of the UAE, who have so far resisted the temptation to disconnect the dirham from the dollar, have to bear that in mind as they contemplate the next steps. Further economic diversification may only be possible at the cost of the dollar peg.

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