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J Ö N K Ö P I N G I N T E R N A T I O N A L B U S I N E S S S C H O O L JÖNK ÖPING UNIV E RS IT Y Oil and the Dutch Disease - The Case of the United Arab Emirates Bachelor Thesis within Economics Author:
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J Ö N K Ö P I N G I N T E R N A T I O N A L B U S I N E S S S C H O O L JÖNK ÖPING UNIV E RS IT Y Oil and the Dutch Disease - The Case of the United Arab Emirates Bachelor Thesis within Economics Author: Maxine Eden Johanna Kärnström Tutor: Professor Per-Olof Bjuggren Jönköping January 2009 Ph.D Candidate Andreas Högberg Ph.D Candidate Erik Åsberg Bachelor Thesis within Economics Title: Oil and the Dutch Disease - The Case of the United Arab Emirates Authors: Maxine Eden Johanna Kärnström Tutors: Per-Olof Bjuggren Andreas Högberg Erik Åsberg Date: Keywords: Dutch Disease, Non-tradable Goods, Resource Movement Effect, Spending Effect, Tradable Goods, United Arab Emirates. JEL Classifications: E31, N55, O13 Abstract According to the Dutch Disease core model a boom in natural resources will eventually lead to a shift of production between sectors: from tradable goods to non-tradable goods. The authors found it interesting to research if United Arab Emirates has been a subject to any of the effects caused by the disease, due to the oil boom during the 1970s and the huge development that has appeared in the country. If the United Arab Emirates would be a victim of the disease the decline in exports of the natural resource will result in a decline in the non-oil tradable goods which will affect the country negatively. Furthermore, the disease can also make it more difficult for the country to deal with the problem of high inflation. A time series covering the period is used to analyse if the United Arab Emirates has experienced symptoms of the disease. Results show that the country has experienced some symptoms of the Dutch Disease during the period since changes in the price of oil caused tradables to shift to the non-tradable sector. Another sign of the disease is the high inflation rate Unite Arab Emirates experienced during the selected period, however high inflation rate could be caused by other factors as well. Furthermore, the larger i n- crease in the non-tradable sector compared to the tradable sector is also an indication of the disease in the country. According to these findings the authors can conclude that United Arab Emirates has experienced symptoms of the disease, however, it cannot be concluded that it has been a victim of the disease. i Kandidatuppsats inom Nationalekonomi Titel: Olja och holländska sjukan - Fallet Förenade Arabemiraten Författare: Maxine Eden Johanna Kärnström Handledare: Per-Olof Bjuggren Andreas Högberg Erik Åsberg Datum: Nyckelord: Effekten av fördelning av tillgångar, effekten av utgifter, Förenade Arab Emiraten, handelsvaror, holländska sjukan, icke handelsvaror. JEL-koder: E31, N55, O13 Sammanfattning: Enligt holländska sjukan-modellen kan en plötslig boom inom naturtillgångar leda till en förskjutning av produktion mellan sektorer, från handelsvaror till icke handelsvaror. Syftet med denna kandidatuppsats är att undersöka om Förenade Arabemiraten har varit ett offer för sjukan på grund av den oförväntade ökningen av naturtillgångar som skedde i landet under 1970-talet. Landet skulle påverkas negativt om det var ett offer för sjukan då nedgången i oljeexporten skulle resultera i en nedgång i sektorn för icke-olje handelsvaror. Detta i sin tur skulle påverka landets BNP negativt. Ytterligare ett problem som Förenade Arabemiraten skulle uppleva om landet är ett offer för sjukan, är svårigheter att kontrollera den höga inflationen. En tidsserieanalys för perioden användes för att undersöka om ökningen av naturtillgångar ledde till symptom av sjukan. Under perioden påverkades landet av förändringen i oljepriset vilket ledde till att handelsvaror skiftade till sektorn för icke handelsvaror, vilket är ett av symptomen för den holländska sjukan. Andra indikationer på att sjukan har förekommit under den testade perioden, är den höga inflationen. Dock kan inflationen ha påverkats av andra faktorer som till exempel den fasta växelkursen till den amerikanska dollarn. Under perioden har sektorn för icke handelsvaror ökat dubbelt så mycket som sektorn för handelsvaror, detta är ytterligare ett symptom av sjukan. Enligt de resultat författarna erhållit kan det konstateras att Förenade Arabemiraten har påvisat symptom av sjukan, däremot kan det inte konstateras att landet har varit ett offer för sjukan på grund av att andra faktorer kan ha påverkat och orsakat de symptom som landet upplevt. ii Table of Contents 1 Introduction Purpose Outline U.A.E Background and Previous Studies Theoretical Framework The TNT Model The Dutch Disease Models The Corden and Neary Core Model The Spending Effect The Resource Movement Effect Dutch Disease - Sachs and Larrain Hypotheses Method and Limitations Empirical Findings and Analysis Data Descriptive Statistics An Earlier Empirical Model The Regression Model Econometric Problems Expected Signs of the Variables Regression Results Conclusion List of References Appendix Figures: Figure 1:...1 Figure 3.1.: 6 Figure 3.3.2:.. 9 Figure 3.3.3:.. 10 Figure 3.4: Figure 4.2: Figure 4.2.1:...15 Figure 4.2.2:...16 iii Tables: Table 2: Table 3.4:..11 Table 4.1: Table 4.4.2:..19 Table 4.5: Appendix: Table 1: Table 2:...26 Table 3:...27 Table 4:...27 Figure 1:..28 iv 1 Introduction Four decades ago, the United Arab Emirates (U.A.E) landscape and infrastructure consisted of not much more than deserts where sheikhdoms survived on fishing, pearling, herding and agriculture. Today, Abu Dhabi and Dubai are two of the most developed emirates in the country dominated by roads, luxury homes, and skylines (consisting of modern glass and steel skyscrapers). The new modern infrastructure has replaced the undeveloped cities that once existed before. To say the least U.A.E has transformed from a desert into a developed country 1 with a high gross domestic product (GDP) reaching $ million 2 in 2007 according to OPEC in According to the Global Competitiveness Report , U.A.E was ranked number 31 globally for its growth competitiveness, and was considered the leading country amongst the Middle East and North African (MENA) countries in 2007 (Hanouz & Yousef, 2007). The large boost in U.A.E s development and economy is founded on the export of the country s oil and petroleum-based products since 1958, when oil was first discovered in Abu Dhabi (Sharply, 2002). Almost 10 percent (%) of the world s current oil reserves are controlled by the U.A.E, enabling it to command more than 16% of OPEC s total reserves (Davidson, 2007). According to OPEC (2007), crude oil production in U.A.E during 2007 reached a daily average of 2.5 million barrels per day. Even though there is a nominal exi s- tence of a federal Ministry of Oil and Petroleum Resources, U.A.E s oil policy remains to exist under the operation of the emirate-level governments (Davidson, 2007). One of the threats towards U.A.E s economy is considered to be a high inflation rate, which is on par with the world s highest (Schwab & Porter, ). It reached 14.3% in 2005 as listed in the World Development Indicators (WDI) database, There are several factors contributing to the increasing prices; the high rate of economic growth, increasing oil prices and the increasing demand in the country due to investment projects in the infrastructure. Furthermore, the situation of U.A.E s currency, the dirham (AED), is pegged at to the U.S. dollar (USD) according to the International Monetary Fund (IMF, 2008). The pegged currency contributes strongly to the inflationary problem, making it more difficult to control fluctuations in the economy. Figure 1 below illustrates the fluctuation in the inflation rate from As can be seen in the figure the U.A.E has experienced peaks in 1975, 1980, 2000 and 2005 and lows can be seen in 1978, 1984, 1998 and Figure 1: Changes in Inflation from Source: Nation Master s Economy Statistics, 2008 Years 1 The authors would like to highlight that U.A.E still consists of deserts. 2 Current prices 1 A discussed topic of U.A.E s economy is their aim to minimize its dependency on oil; therefore much focus has been targeted on diversifying the economy during the past two decades. In turn, making it more dependent on the service sector: especially high-class tourism as well as expanding the international finance sector. In both developed and developing countries, a natural resource boom, (as experienced in U.A.E) has triggered the so called Dutch Disease. A theory that originates from the Netherlands in the 1970s, basically explaining a decline in the traditional manufacturing sector when the country experiences a boom in their natural resource. The Dutch Disease indicates that the natural resource abundant factor, (natural oil in U.A.E s case), triggers an appreciation of the dome s- tic currency. In a pegged-currency economy on the other hand, the inflation rate increases. A result of the increasing export sales and the rising real exchange rate (RER). In turn, other non-resource exporters are affected at the same time and the manufacturing sector experiences a constrained activity to compete in the world market. Furthermore, the agricultural sector undergoes a decline as labour moves to either the booming sector or the non-tradable sector (Sachs & Larrain, 1993). The case of the Dutch Disease would be a problem to the U.A.E since it causes the shift of labour and production for the tradable sector to the non-tradable sector causing a decline in the country s exports of manufacturing and agricultural goods.. The decline in exports of U.A.E s traditional tradable goods decreases production of the goods affecting the country s economy in a negative way. Furthermore, since U.A.E is faced by a high inflation rate the possibility of the Dutch Disease could increase the inflation rate even more, putting further constrains on the economy in how to deal with the existing inflationary problem. 1.1 Purpose The purpose of this paper is to study U.A.E s development in economic growth since 1975 until 2005 and establish if there are any signs of the Dutch Disease by testing the ratio of tradable goods to non-tradable goods and the effects by other macroeconomic variables. Therefore the authors of the thesis apply the following research question. Did the oil boom in the U.A.E during the 1970s lead to symptoms of the Dutch Disease throughout the period and if so, to what extent? 1.2 Outline The authors have focused on giving the readers an introduction to the topic in hand and purpose for the first section in this thesis. As the readers may not be familiar with the chosen country, the authors present a brief history of the economy followed by previous studies in the second section. Section three contains a relevant definition, applicable theories illustrated with graphs as well as a summary of the applied theoretical models and following this are the hypotheses. The next section presents the data for the macroeconomic variables implemented, descriptive statistics with analysis, followed by an earlier empirical model and adapted regression models applied for the authors purpose. Furthermore, econometric problems and the OLS test results and analysis are also presented in section four. Finally, the authors provide conclusions of the thesis in section five as well as suggestions for further research. 2 2 U.A.E Background and Previous Studies U.A.E consists of the seven emirates Abu Dhabi, Dubai, Sharjah, Ra s al-khaimah, Ajman, Umm al-qaiwain and Fujairah, which are located on the southern Arabian Gulf. On the 2nd of December 1971, the country became independent after being under British rule for a period of 70 years. The independence and discovery of oil triggered the economic development in U.A.E which led to a huge expansion in the population. In 2007 the population reached 4.36 million as listed in the World Bank, Five decades earlier there were only a few hundred thousand inhabitants (Davidson, 2007).The population boom in U.A.E is a result of the increased demand for labour throughout the past four decades and consists for the most part (83%) of labour from foreign countries referred to as expatriates (Davidson, 2007). According to the International Labour Organization (ILO, 2008) total e m- ployment in 2005 reached 2.47 million compared to a low total unemployment of 0.79 million. Furthermore, United Nation s (UN) database illustrates the division of the labour from two perspectives; first from the year 2000 compared to the changes that prevailed in Female participation and male participation in 2000 consisted of 34.4% in the former group and 92% in the latter group. As stated in the introduction, one of the impacts when an economy is experiencing signs of the Dutch Disease is the high inflation rate followed by a change in the real exchange rate. Fluctuations in the real exchange rate can cause resources and production to reallocate between the economy s sectors of tradable and non-tradable goods and services and is therefore regarded as an important price in the economy according to Karam (2001). The U.A.E is one of the countries in the Middle East which follows a pegged (or fixed) exchange rate regime, in which foreign central banks stand ready to buy and sell their currencies at a fixed price in terms of dollars (Dornbush, Fisher & Startz, 2008). The currency of the U.A.E, the AED was first officially pegged against the USD in By the end of 1977 fluctuations occurred widely. One year later it became pegged to the Special Drawing Right 3, (SDR), whilst the USD remained as the intervention currency with the initial selling rate of 3.88 AED to 1 USD. Since November 1980, the currency has been hard pegged to the USD at AED for 1 USD. For over two decades the USD had been used as an anchor currency in practice when it became the official anchor currency in The decision to make the USD an anchor curreny was made by the member nations of the Gulf Cooperation Council (GCC) in order to establish a common currency in 2010 (Schuler 2004). The U.A.E and the effects from the oil industry has not been studied to any great extent. However some studies on the Dutch Disease concerning other countries have been conducted, but these studies are mainly theoretical and lack econometric testing. The studies with statistical analysis contain time series, more observations and flexible exchange rates (which could be included in the regression model). In order to make it more comprehensive and easier for the reader, the previous studies on similar topics is listed in table 2 below. 3 SDR was originally created in 1969 by the IMF in order to support the Bretton Woods fixed exchange rate system. Today, SDR s fun ction is to serve as IMF s unit of account as well as fo r other international o rganizations (IMF, 2008). 3 Table 2: Previous Studies Conducted on Similar Topics Earlier Literature H. Falck (1992) K. Miagra, O De Silva (1994) H. Imai (2000) N. Oomes, & K. Kalcheva (2007) Key Findings Dutch Disease shows that it is possible for foreign aid to give rise to an appreciation of the RER, causing deteriorating effect on the international sectors in Tanzania. Discusses alternatives which may cure the disease. Stresses the importance of government policies during a resource boom by using the Dutch Disease as a case study of several countries, e.g. Nigeria and Mexico. Highlights that recent developments in trade theory has to some degree justified government policies which would have been predicted as irrational according to standard economic theory. Fiscal, monetary and exchange rate policies assumes to maintain the domestic demand by interaction by governments. Discusses if Hong Kong s high inflation was due to The Balassa- Samuelsson Effect or the Dutch Disease. A case of a fixed currency. Results show that the Dutch Disease was the main reason for the long-term rate of inflation. Even though a country (Russia in this case) may have all the symptoms it still may be difficult to diagnose if the economy is suffering from the disease. Symptoms of the disease can be explained by other factors. Rising levels of remittances and spending effects lead to the disease. 4 3 Theoretical Framework In order to comprehend the Dutch Disease theory the authors used Sachs and Larrain s (1993) theoretical model of tradable (T) and non-tradable goods 4 (NT), also known as the TNT Model. The model is a simple theoretical model which describes the diversification of goods from tradables to non-tradables. 3.1 The TNT Model According to Sachs and Larrain (1993) the most important assumptions is that N can neither be exported nor imported and its domestic consumption and production must be equivalent. The opposite applies for T, consumption and production domestically can di f- fer because of the possibility of imports and exports T. In this specific model, two goods are produced and consumed: T and N by one factor of productivity which is labour. The supply side obtains two linear functions: Q T = a T L T (T) and Q N = a N L N (N), where production is dependent on labour. L T and L N accounts for the amount of labour used, whilst a T and a N are the marginal productivities of labour for the two sectors. In other words a T or a N units more of output is achieved if one extra unit of labour is applied in either sector. Due to the linear functions, a T and a N also account for average productivities. The demand side of the TNT model circles around consumption decisions which do not include investment spending. Total absorption, i.e. spending on T and N is expressed in the equation as followed: A = P T C T + P N C N. Total absorption is defined by A and levels of consumption for T and N by C T and C N. P T and P N corresponds to the price of the goods. Furthermore, Sachs and Larrain (1993) assume if the ratio C T /C N is fixed, then households consume C T and C N in fixed proportions, (regardless of relative prices). If overall spending increases, it is followed by an increase in consumption in T and N by the same proportion and vice versa. Figure 3.1 below illustrates the production possibility frontier (PPF), the consumption line and the market equilibrium for T and N in a country. The PPF shows each quantity of Q T that is produced in order to produce the maximum quantity of Q N. If Q N = a N L then Q T = 0, represented by point B in the figure. Then the factor of productivity labour is located in the N sector. If Q N = 0 and Q T = a T L, then labour is located in T (point D in the figure). The slope of the PPF is equal to P T /P N, i.e. the relative price of T in terms of N, which is also referred to as the real exchange rate, e, in the TNT model. Therefore, a N /a T = P T /P N = e. The production of a unit of a good either in T or N and the labour cost used is equivalent to the output price. The consumption line is represented by the 0C line in the figure. When absorption (A in the equation above) is low then households spend an amount equal to point D and when absorption is high household spending is equal to H. At point D, C T and C N are both low and at point H, C T and C N are high. The ratio C T /C N is fixed as absorption 4 A tradable goods and non-tradable good is defined according to the standard industrial classification (SIC), developed by the UN. In general a tradable good is produced in agri culture, mining, quarrying or manufacturing and can be traded, a non-tradable good can not be traded such as services within retail trade, hotels, restaurants, businesses, financing and real estate. 5 increases or decreases along the 0C line. Point D represents household consumption, where C D N and C D T consist of the consumptions of N and T respectively. Indicating that production of N must also equal to C D N5, hence Q F N = C D N. Therefore the production point has to be on the PPF at the same point where Q N = C N, i.e. point F. The production point for absorption and point D, household consumptions re
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