The Dutch Disease in Reverse Iceland’s Natural Experiment

Thorvaldur GylfasonGylfi Zoega

Key points

• Abundant natural resources brought Iceland a systemically overvalued currency, with adverse effects on the secondary tradable sector

• During 2003-2008 another national treasure, the sovereign’s AAA rating, was used to attract foreign capital, elevating the real exchange rate even further

• The financial collapse in 2008 left Iceland with a large foreign debt without the possibility of rollovers in foreign capital markets

• The currency plunged, producing a bout of the Dutch disease in reverse as witnessed, in particular, by a massive expansion of tourism after the crash

Key points

• Insofar as the trouble with abundant natural resources has to do with the real appreciation of the currency, the depreciation resulting from a financial crash can be viewed as a case of the Dutch disease in reverse

• Just as an appreciation of the currency weakens the current account, a massive depreciation following a financial crash stifles imports and strengthens exports, paving the way toward economic recovery

Literature

• Recent literature highlights several channels through which natural resource abundance, if not well managed, may retard economic growth – Rent seeking– Dutch disease– Poor governance– Political or ethnic conflict– Corruption– Autocracy– Excessive borrowing– Low levels of education

Literature

• Our 1999 model showed how a large and volatile primary sector would adversely affect the output of tradable goods by increasing real wages and the real exchange rate, lowering the relative price of tradable goods and hampering investment

• If learning-by-doing occurs mostly in the secondary export sector and not in the primary sector, we also showed that natural resource booms are likely to hamper growth by discouraging employment and investment

Parallels

• Foreign aid inflows share important properties with natural resource discoveries– Aid constitutes an unrequited transfer emerging like

manna from heaven– Aid inflows have about them an aura of ‘other people’s

money’ which, like lottery winnings, as well as due to their transitory and often volatile nature, may seem easy to fritter away

– Like foreign aid that may create an encouragement to divert the aid from its intended beneficiaries, natural resource abundance sometimes tends to attract the wrong sort of people to politics by offering them opportunities to divert rents from their right owners

Parallels

• Inflows of foreign credit can exert a similar manna-from-heaven effect on its recipients as resource windfalls and foreign aid …– … not least if the borrowing nation behaves as if

there is no tomorrow and bankers revel in their role as rentiers

• In some cases, resource windfalls, foreign aid and rapid capital inflows may invite plunder … – … with royal families, clerics, generals, politicians

and bankers sitting in the driver‘s seat

GNI per capita 1990-2013(Current international dollars, ppp)

Denmark and Iceland Greece, Iceland, Ireland, Latvia

Source: World Bank, World Development Indicators.Shaky recovery accompanied by labor market unrest

(doctors on strike!) and danger that relaxation of capital controls will cause further depreciation

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

50000

Denmark

Iceland

0

5000

10000

15000

20000

25000

30000

35000

40000

45000Greece

Iceland

Ireland

Latvia

Background

Exports of goods and services and manufactures

Exports 1960-2012 (% of GDP)

Manufactures exports 1962-2012 (% of total exports)

Iceland’s export share in GDP was flat 1870-2008

19601964

19681972

19761980

19841988

19921996

20002004

20082012

0

10

20

30

40

50

60

70

Denmark

Iceland

19621965

19681971

19741977

19801983

19861989

19921995

19982001

20042007

20100

10

20

30

40

50

60

70

Denmark

Iceland

Source: World Bank, World Development Indicators.

When the króna plunged,

exports shot up …

Imports and domestic creditImport volume 2000-2011

(2000 = 100)Domestic bank credit 1960-2012

(% of GDP)

0

20

40

60

80

100

120

140

160

180

200Denmark

Iceland

0

50

100

150

200

250

300

350

Denmark

Iceland

Source: World Bank, World Development Indicators.

… and imports collapsed

Investment and adjusted net savingGross investment 1965-2012

(% of GDP)Adjusted net saving 2005-2012

(% of GNI)

Source: World Bank World Development Indicators.

-10

-5

0

5

10

15

20

25

30

35

40DenmarkIceland

20052006

20072008

20092010

20112012

-10

-5

0

5

10

15

20

25

30

35

40Denmark

Iceland

20002001

20022003

20042005

20062007

20082009

20102011

2012

-10%-5%0%5%

10%15%20%25%

Iceland: Collapse of net investment

% of GDP

Intended to reflect

“real” difference

between production

and consumption

Model• Primary output is stochastic and follows a Brownian

motion subject to random productivity shocks and is independent of the real exchange rate:

• dW represents the increment of a Wiener process , having a zero mean and a unit SD

• The drift term reflects growth in primary output while the stochastic term represents the vicissitudes of, e.g., commodity prices that make primary output rise or fall at random, creating uncertainty about output in the primary sector

Model

l= real exchange rate

(appreciation makes fall)

r = saving

Secondary output is deterministic

Model

The drift term, with < 0 denoting appreciation – a fall in the relative price of tradable goods – signals the Dutch disease

The volatility of the real exchange rate λ described by the stochastic term may be no less important in its effect on investment for other export industries and import-competing industries

Derive and play with stochastic equation for ys:

dys = Adt + BdW

Again

Model

• Employment and output in secondary sector depend on the real exchange rate λ, and hence on primary-sector output and external debt as well as primary-sector wages

• A primary-sector boom has an immediate adverse effect on secondary-sector output by reducing λ (i.e., by making the currency appreciate), a key aspect of the Dutch disease

• Firms will decide to invest whenever the real exchange rate λ exceeds – i.e., falls below – the threshold

Model

• Investment threshold is a function of the parameters of the model– Rise in primary-sector wage raises secondary-

sector wages, lowering profits and lifting the real exchange threshold, making investment less likely

– Volatility of λ, created by volatility of primary output, will (a) raise profits due to convexity in the profit function and (b) lift the threshold by increasing the option value of investment

• Second effect dominates, so increased volatility of primary output makes investment less likely on balance

Model

• Investment threshold is a function of the parameters of the model– Positive trend growth of primary output, , has a

negative effect on the trend growth of λ (i.e., ), which raises the investment threshold and makes investment less likely

– Increase in the fixed factor endowment, T , lowers the investment threshold so firms start investing at a lower real exchange rate λ

Data: Real exchange rate, current account, tourism and non-primary merchandise exports

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

-25

-20

-15

-10

-5

0

5

10

60 65 70 75 80 85 90 95 00 05 10

currentaccount

real exchangerate

real exchangerate

currentaccount (%)

The current account measures the current account surplus as a ratio to GDP.The real exchange rate is defined as the relative price of tradables.

The real exchange rate and the current account

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

0

50

100

150

200

250

300

350

60 65 70 75 80 85 90 95 00 05 10

real exchangerate

change innum ber oftourists (%)

real exchangerate

tourists

Tourism is calculated as the number of foreign tourists as a proportion of thepopulation of Iceland. The real exchange rate is defined as the relative price of tradables.

The real exchange rate and tourism

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

-20

-10

0

10

20

30

40

50

60 65 70 75 80 85 90 95 00 05 10

real exchangerate

change innum ber oftourists (%)

changer in numberof tourists

real exchangerate

Tourism is calculated as the number of foreign tourists as a proportion of thepopulation of Iceland. The change is calculated as the change in the proportion betweenany two years. The real exchange rate is defined as the relative price of tradables.

The real exchange rate and the CHANGE in the number of tourists

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

0

10

20

30

40

50

60

70

60 65 70 75 80 85 90 95 00 05 10

real exchangerate

otherexports (%)

real exchangerate

otherexports

Other exports are calculated as the ratio of non-primary merchandise exports tototal merchandise exports. The real exchane rate is defined as the relative price of tradables.

The real exchange rate and other exports

Real exchange rate and the current account

Real exchange rate and change in tourism

Real exchange rate and tourism

Real exchange rate and other exports

VAR model

E = real exchange rate (i.e., λ)CA = current account (% of GDP)T = change in tourists (% of population)NP = change in non-primary exports (% of total exports)

E, CA: No unit roots

T, NP: Unit roots

MLE estimation results for VAR(2)1960-2012 Log(E) CA T NPLog(E-1) 0.96* 33.29* 10.02 8.71Log(E-2) -0.22 -30.18* 26.50* -11.50*CA-1 -0.00 0.52* -0.51* -0.21CA-2 0.00 0.10 0.23 0.15T-1 -0.00 -0.12 0.35* 0.13T-2 -0.03 -11.65 0.35* 12.78NP-1 0.06 11.94 -0.60* -9.36NP-2 0.01 -0.02 -0.42 -0.24R2 0.60 0.65 0.58 0.26

t-values not shown; * denotes statistical significance at the 5% level.

VAR Results: Impulse response functions to a rise in the price of tradable goods

-.08

-.04

.00

.04

.08

.12

1 2 3 4 5 6 7 8 9 10

Response of LOG(E) to LOG(E)

-4

-2

0

2

4

6

1 2 3 4 5 6 7 8 9 10

Response of CA to LOG(E)

-6

-4

-2

0

2

4

6

1 2 3 4 5 6 7 8 9 10

Response of D(T) to LOG(E)

-2

-1

0

1

2

3

4

1 2 3 4 5 6 7 8 9 10

Response of D(NP) to LOG(E)

Response of Log(E) to Log(E) Response of CA to Log(E)

Response of T to Log(E) Response of NP to Log(E)

Tourism and food exportsTourist arrivals 1995-2011

(% of population)Food exports 1962-2012

(% of merchandise exports)

Source: World Bank World Development Indicators.

0

20

40

60

80

100

120

140

160

180

200

France Greece Iceland

Mauritius Spain

0

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60

80

100

120France GreeceIceland MauritiusSpain

Discussion

• Capital inflows resemble natural resource windfalls in that both events flood the recipient country with easy money, triggering similar reactions among the natives– General euphoria– Real appreciation of the currency (Dutch disease)– Reckless public policies in the belief that anything goes– Rent seeking, even plunder

• Large capital outflows can be viewed as the Dutch disease in reverse, triggering an economic downturn and real depreciation of the currency

Fini

Investment thresholds I

Threshold vs. wbar Threshold vs. σ

Source: Authors’ computations.

0.5

0.525

0.55

0.575000000000001

0.600000000000001

0.625000000000008

0.650000000000009

0.67500000000001

0.700000000000001

0.725000000000001

0.750000000000008

0.775000000000009

0.8

0.825000000000001

0.850000000000001

0.875000000000008

0.9

0.925

0.950000000000001

0.975000000000001

1 1.02499999999998

1.05

1.075

1.1

1.125

1.14999999999998

1.175

1.2

1.22499999999998

1.25

1.27499999999998

1.3

1.325

1.35

1.375

1.4

1.42499999999998

1.45

1.47499999999998

1.5

0

0.1

0.2

0.3

0.4

0.5

wbar

thre

sh

old

s

0.05

0.0525

0.055

0.0575

0.06

0.0625

0.065

0.0675

0.07

0.0725

0.075

0.0775

0.08

0.0825

0.085

0.0875

0.09

0.0925

0.095

0.0975

0.1

0.1025

0.105

0.1075

0.11

0.1125

0.115

0.1175

0.12

0.1225

0.125

0.1275

0.13

0.1325

0.135

0.1375

0.14

0.1425

0.145

0.1475

0.15

0

0.1

0.2

0.3

0.4

0.5

s

thre

sho

lds

Appendix

Investment thresholds II

Threshold vs. η Threshold vs. T

-0.02

-0.0190000000000003

-0.018

-0.017

-0.016

-0.015

-0.014

-0.013

-0.012

-0.011

-0.01

-0.00900000000000001

-0.00800000000000002

-0.00700000000000001

-0.00600000000000001

-0.00500000000000001

-0.00400000000000001

-0.00300000000000001

-0.00200000000000001

-0.001

0 0.001

0.00200000000000001

0.00300000000000001

0.00400000000000001

0.00500000000000001

0.00600000000000001

0.00700000000000001

0.00800000000000002

0.00900000000000001

0.01

0.011

0.012

0.013

0.014

0.015

0.016

0.017

0.018

0.0190000000000003

0.02

0

0.1

0.2

0.3

0.4

0.5

h

thre

sh

old

s

0.5

0.525

0.55

0.575000000000001

0.600000000000001

0.625000000000008

0.650000000000009

0.67500000000001

0.700000000000001

0.725000000000001

0.750000000000008

0.775000000000009

0.8

0.825000000000001

0.850000000000001

0.875000000000008

0.9

0.925

0.950000000000001

0.975000000000001

1 1.02499999999998

1.05

1.075

1.1

1.125

1.14999999999998

1.175

1.2

1.22499999999998

1.25

1.27499999999998

1.3

1.325

1.35

1.375

1.4

1.42499999999998

1.45

1.47499999999998

1.5

0

0.1

0.2

0.3

0.4

0.5

Tth

resh

old

s

Source: Authors’ computations.