More Economics: "Dutch Disease"

Source: http://www.imf.org/external/pubs/ft/fandd/2003/03/ebra.htm

(Sorry for another general economics post. We are getting to Zhongguancun slowly but surely ;)

What is it about those Netherlandians -- the Dutch? According to the IMF article cited above, in the 1960s natural gas deposits were discovered in the North Sea. The sale of these deposits made the Netherlands very rich. However, a consequence was an increase in the value of Dutch guilder. The final result was a negative impact on various sectors of the Dutch economy, with an emphasis on non-natural gas exports.

This is a general phenomenon in the international economy. It holds for any natural resource (oil, gold, diamonds), and also foreign assistance (aid) and foreign direct investment (FDI).

The explanation, as far as I have grasped it, has three parts. The first part is that increased sales of the new resource (say) make the amount of a country's foreign reserves jump, assuming the entire country is the recipient of the benefits of sales. With increased foreign reserves, there will be consequences for the money supply of domestic currency. One way to avoid these consequences would be to spend the entire amount of profits from the new natural resource on imports (money in equals money out).

The second part of "Dutch disease" is the effect on the domestic money supply (where "domestic" means the country which discovered the new natural resource (or aid or FDI)). There are two possibilities based on whether or not the foreign exchange rate is fixed or flexible. If fixed, the exchange rate does not change but as more foreign exchange is converted into domestic currency, there is more domestic currency (to keep rate fixed, central bank must print more money). With more money available, more goods and services will be purchased causing prices to rise--more demand and constant supply causes rise in prices. Put another way, purchasing power parity has decreased. The second possible effect on the money supply occurs if the exchange rate is flexible--in this case more foreign currency causes the exchange rate to rise. The mechanism is more supply in this case: a greater supply of foreign currency with a constant demand for foreign currency results in less domestic currency required to purchase foreign currency. In both fixed and flexible exchange rate cases, the overall effect is that the country's exports are weakened because of the money supply effects.

The loss is purchasing power parity or the rise in exchange rate of domestic currency both make exports more expensive for other countries. Resources in the country shift towards exploiting the natural resource and away from developing domestic industry, assuming a "zero-sum" allocation of development potential. With less development of other (non-natural resource) industries, and increases in exchange rate (or loss of purchasing parity) both negatively influence a country's economy.

This is Dutch disease and has been observed in Columbia (coffee) and near the Caspian Sea (Kazakhstan, Azerbaijan, etc.) with gas and oil. There are clearly other examples.

Discussion: Is China's FDI permanent? With it ultimately result in a "Dutch disease"? Can zones within the country (for example, Zhongguancun, Shenzhen, or Pudong) come down with "Dutch disease" or is it limited to national economies?