Multi-Asset Insights: Is FX adjustment a cure for 'Dutch Disease'?
What is Dutch Disease and its symptoms?
Following the Netherlands’ discovery of a large natural gas field in the late 1950s, the country’s economic model changed significantly to focus on developing natural resources, leading to a gas export boom.
Capital and labour were allocated to the booming industry, while exports of natural gas brought in a large amount of capital, which pushed up the Dutch guilder.
One of the symptoms of Dutch Disease is that the booming industry crowds out the non resources sectors of the economy.
In the case of the Netherlands, manufacturing’s share of exports and gross value added (GVA) fell significantly given weakened competitiveness following the strong currency appreciation.
Employment in manufacturing contracted subsequently in the 1970s, which was followed by a recession in the early 1980s.
The Economist coined the phrase “Dutch Disease” to describe this phenomenon of a foreign exchange (FX) led decline in competitiveness, referring to this classic example of the Netherlands.
Who in the world has contracted Dutch Disease?
Among others, it looks like Australia and Canada have fallen victim to the disease.
Both countries have seen substantial increases in the importance of their natural resources sectors as they directly fed Chinese demand for raw materials during the nation’s rapid industrialisation.
This created upward pressure on growth and wages and, ultimately, higher interest rates.
The strong appreciation of the Australian and Canadian dollars (AUD and CAD) from 2001 is a classic symptom of Dutch Disease.
In addition, we have also seen the reallocation of capital from manufacturing to natural resources investments – further evidence that Australia and Canada have contracted the disease.
Chart 1: Australia and Canada commodity price indices vs real effective exchange rates (REER)
Source: Datastream. Monthly data from January 2000 to October 2015. All indices rebased to value of 100 as of January 2000.
What is the cure for the disease?
The only cure for the Dutch Disease is a substantial adjustment in the real effective exchange rate to revive those areas of the economy which previously suffered from the overvaluation of the exchange rate.
Since the peak of the commodity super-cycle and the subsequent peak in resource investment, we have seen exchange rates adjust lower as terms of trade have collapsed and interest rates have been cut to support growth.
G10 commodity currencies have depreciated by roughly 25-35% vs the US dollar and 20-30% in REER terms since 2010’s peak in commodity prices.
What is our diagnosis for patients AUD and CAD?
In Australia, we believe further adjustments are required for the disease to be cured.
Currently the investment in the mining sector is at 4% of GDP.
While this represents a significant drop from 6.5% at its peak, we believe it needs to fall to the long-term average of 1.5% of GDP.
This is likely to outweigh any recovery in manufacturing investment, which has yet to show signs of picking up.
As a result, growth and inflation are likely to remain weak, putting downward pressure on interest rates which push the AUD REER further down to allow manufacturing investment to begin to recover.
We estimate a further 20% potential downside to the AUD given the severity of its disease.
Chart 2: Australia manufacturing / mining investment (% GDP)
Source: Datastream. Monthly data from December 1987 to June 2015
Our patient CAD looks a little better, as there are some signs that exchange rate sensitive sectors are beginning to pick up, for example the increasing volume of automotive exports.
Though modest, it appears that Canada is further down the road to rebalancing.
However, there are also signs that economic activity is shifting from natural resources to credit and housing given declining interest rates.
Given the significant imbalances in Canada’s housing market, this form of rebalancing is unlikely to be sustainable.
For this patient, our diagnosis is that a further 10% depreciation in the CAD is possible.
Chart 3: Canadian energy & automotive as % of exports
Source: Datastream. Monthly data from December 1997 to September 2015
While the healing process for the AUD and CAD has started, we believe there is still some way to go.
As such, we remain structurally bearish on these currencies until they show signs of health again.
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