Research Brief
Aid and Dutch Disease

In 1959 the Netherlands discovered vast natural gas resources in the North Sea. This discovery led to a rapid increase in the country’s national wealth. However in the 1960s the Netherlands experienced an economic crisis. The natural gas reserves were one of the causes of this crisis, as the Dutch Guilder rose in value relative to other currencies exports of non-gas commodities became less competitive on the world market leading to an overall decline in the country’s manufacturing sector. The term 'Dutch disease' was coined to describe this process.

Since then Dutch disease has become a widely-studied economic phenomenon, and it has been noted that its causes may not be limited to the discovery of natural resources. Significant increases in foreign direct investment (FDI) or overseas development aid (ODA) could have a similar effect, driving up the real exchange rate and causing a shift in the structure of a recipient country’s economy.

While such a shift will not necessarily negatively impact social welfare it does have the potential to worsen income distribution if the poor own resources used in international trade. Furthermore, internationally-traded goods have positive externalities and therefore such a resource reallocation could lead to a reduction in aggregate productivity. In the WIDER Working Paper 'Aid and Dutch Disease in Sub-Saharan Africa', Dave Fielding and Fred Gibson address the question of the macroeconomic effects of aid inflows, looking at both how aid effects exchange rates, and at what factors help explain cross-country variation.

Most existing econometric studies point to a significant correlation between aid inflows and real exchange rates, however there is significant variation in terms of the size of the expected effect. The authors’ findings regarding the relationship between aid inflows and real exchange rates largely match those found in the existing literature; in most of the countries they examine an increase in aid flow has led to a significant, short-term, increase in real exchange rates, meaning both that the country will have greater purchasing power when importing goods, and that exporting goods will become more profitable. However this increase is negatively correlated with responses in terms of inflation-adjusted GDP, a clear sign of the Dutch Disease effect. The results also show that effect of aid on real exchange rates varies considerably across the countries studied, and it is to the potential explanations for this variation that we shall now turn.

Factors Explaining Cross-country Variation

The authors investigate six factors which could potentially explain the variable effects aid inflow has on the macroeconomy of different countries:

1. Fixed capital to GDP ratio. If the annual proportion of GDP invested in fixed capital projects is related to the amount invested in capital specific to goods that are not traded internationally then we should expect countries in which this ratio is high to experience a smaller exchange rate increase following an increase in aid.
2. Average level of per capita GDP. If the marginal return of capital is low then the effect of investment following an aid increase will be less and the effect on the exchange rate will be mitigated. In a country with higher levels of per capita GDP may experience a larger real exchange rate appreciation following an increase in aid.
3. The average ratio of the value of trade to GDP. A high ratio of trade to GDP indicates a country that has had less extensive trade restrictions and where there is a smaller gap between the returns expected on tradeable and non-tradeable goods.
4. Whether the country has a hard exchange rate peg. Countries with such a peg may experience a more rapid return to exchange rate stability.
5. Political stability. Countries with weak institutions may experience greater appreciation following an increase in aid due to negative effect such institutions can have on economic productivity.
6. Whether the country is landlocked. The range of goods that are traded internationally will depend in part on transport costs. Countries which are landlocked are likely to face higher transport costs and are therefore likely to face higher levels of exchange rate appreciation following an increase in aid.

While there are clear reasons why all of these variables may have an effect on the extent of real exchange rate appreciation following an increase in aid, the authors’ results show that only some are significant. The ratio of trade to GDP, the existence of a hard exchange rate peg and political stability do not appear to be useful variables in attempting to explain the variation noted earlier. Per capita GDP is associated with a higher real exchange rate appreciation in the short-term, but seems to become influential as time goes on. By contrast higher investment to GDP ratios appears to mitigate exchange rate increases and this factor seems to become more significant over time. Finally real exchange rate increases do appear to be higher in landlocked countries.

As real exchange rate increases do seem to lead to instances of Dutch Disease, policy makers need to take these factors into account when making decisions about aid disbursement. The goal of aid is to encourage growth and lift people out of poverty, if instead aid leads to countries that are overly reliant on the export sector the potential for growth in employment may be limited, and the withdrawal of aid may lead to great economic instability.

The authors conclude that future aid packages should contain measures designed to mitigate real exchange rate appreciation. While aid, which aims to improve institutional quality and macroeconomic reform, has wider benefits it does not help to counter real exchange rate appreciation unless it has an impact on capital productivity in the non-traded goods sector. This effect, therefore, must be taken into account when designing aid packages. If it is not, aid inflows are, at least in the short term, likely to generate economic imbalances which diminish their effectiveness.