In this paper we describe the medium-run macroeconomic effects and long-run development consequences of a financial Dutch disease that may take place in a small developing country with abundant natural resources. The first move of such a peculiar Dutch disease is on financial markets. An initial surge in FDI targeting domestic natural resources sets in motion a perverse cycle between exchange rate appreciation and mounting short-term capital flows. Such a spiral easily gives rise to exchange rate volatility, foreign capital reversals, and sharp macroeconomic instability. In the long run, such acute macroeconomic instability as well as overdependence on natural resource exports all dampen the development of non-traditional tradable good sectors and curtail labor productivity dynamics. We advise the introduction of constraints to short-term capital flows, in the form of taxes on exchange rate-based capital gains, to tame exchange rate/capital flows boom-and-bust cycles. We also provide support to a developmentalist monetary policy that targets competitive nominal and real exchange rates in order to favor the process of production and export diversification. Such a policy stand can be particularly effective to counter-act the long-run negative effects of the financial Dutch disease we describe.
Keywords: Financial Dutch Disease, exchange rate volatility, macroeconomic instability, developmentalist monetary policy
JEL classification: F32: Current Account Adjustment; Short-term Capital Movements O14: Industrialization; Manufacturing and Service Industries; Choice of Technology O24: Development Planning and Policy: Trade Policy; Factor Movement; Foreign Exchange Policy
Download: Working Paper PKWP1410