Oil and Dutch Disease

scotchs FOR BUSINESS Project Report on Oil and the recent ?Dutch malady? The Case of the United Arab Emi charge per units Submitted by Amitava Manna 1 paginate Table of Contents Introduction .. 2 Purpose UAE Background . 4 Theoretical Framework 4 Empirical Findings and Analysis . 6 info .. Descriptive Statistics 6 The regress Model 8 Conclusions .. 10 2Page Introduction Four decades ago, the United Arab Emirates (U. A.E) landscape and infrastructure consisted of non much more than deserts where sheikhdoms survived on fishing, pearling, herding and agriculture. Today, Abu Dhabi and Dubai atomic number 18 deuce of the or so developed emirates in the province dominated by roads, luxury homes, and sky nones (consisting of modern glass and steel skyscrapers). The new modern infrastructure has replaced the undeveloped cities that at adept time existed before. To say the least U. A. E has transformed from a desert into a developed commonwealth1 with a mellow gross mun icipal product (gross domestic product) reach $192. 03 million2 in 2010. According to the Global Competitiveness Report 2008-2009, U. A. E was be number 31 glob all in ally for its growth competitiveness. The large boost in U. A. E? s development and economy is founded on the export of the country? s fossil oil and petroleum- found products since 1958, when oil was first discovered in Abu Dhabi. approximately 10 percent (%) of the world? s veritable oil militia are controlled by the U. A. E, enabling it to command more than 16% of OPEC? s total reserves. The aim of the U. A. E? economy is to minimize its dependency on oil therefore much focus has been targeted on diversifying the economy during the early(prenominal) ii decades. In turn, making it more restricted on the expediency field, especially in high spirits-class tourism as well as expanding the transnational finance empyrean. In both developed and developing countries, a essential resource thrive, (as experien ced in U. A. E) has triggered the so called Dutch disorder?. It is a theory that originates from the Netherlands in the 1970s, basically explaining a pooh-pooh in the tralatitious manufacturing welkin when the country experiences a boom in their earthy resource.The Dutch Disease indicates that the natural resource abundant ingredient triggers an appreciation of the domes- tic property. 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 verdant sector undergoes a dec kris as application moves to either the prosperous sector or the non-tradable sector. The case of the Dutch Disease would be a problem to the U. A. E since it causes the shift of labor and toil for the tradable sector to the non-tradable sector causing a decline in the country? exports of manufacturing and agricultural goods. The decline in exports of U. A. E? s traditional tradable goods de-creases employment of the goods affecting the country? s economy in a controvert way. Purpose The occasion of this paper is to study U. A. E? s development in stinting growth since 1975 and represent if there are any signs of the Dutch Disease by test the dimension of tradable goods to non- tradable goods and the imprints by other macroeconomic variable stars. 3Page UAE Background U. A. E consists of the seven emirates Abu Dhabi, Dubai, Sharjah, Ra? al-Khaimah, Ajman, Umm al-Qaiwain and Fujairah, which are located on the southern Arabian Gulf. On the 2nd of celestial latitude 1971, the country became commutative after being under British overlook for a gunpoint of 70 years. The independence and discovery of oil triggered the economic development in U. A. E which led to a huge refinement in the population. The population boom in U. A. E is a subject of the increased demand for labor throughout the past four decades and consists for the some part (83%) of labor from foreign countries referred to as expatriates. United Nation? (UN) database illustrates the contri entirelyion of the labor from two perspectives first from the year 2000 compared to the transmits that prevailed in 2010. Female meshing and male participation in 2000 consisted of 34. 4% in the former sort out and 92% in the latter group. As stated in the introduction, unity of the impacts when an economy is experiencing signs of the Dutch Disease is the high rising prices rate followed by a channel in the tangible supercede rate. Fluctuations in the real exchange rate preempt cause resources and achievement to reallocate among the economy? sectors of tradable and non- tradable goods and ser criminalitys and is there-fore regarded as an important wrong in the economy. The U. A. E is one of the countries in the Middle East which follows a pegged (or mend) ex- change rate regime, in which foreign central banks stand ready to buy and make do their currencies at a fixed cost in hurt of dollars. The property of the U. A. E, the AED was first authoritatively pegged against the USD in 1974. By the end of 1977 fluctuations occurred widely. For over two decades the USD had been use as an anchor currency in practice when it became the official anchor currency in 2002.The decision to make the USD an anchor currency was made by the member nations of the Gulf Coopeproportionn Council (GCC) in instal to establish a common currency in 2010. The U. A. E and the progenys from the oil industry fix not been studied to any great extent. tho some studies on the Dutch Disease concerning other countries relieve oneself been conducted, moreover these studies are mainly theoretical and lack econometric testing. The studies with statistical epitome contain time series, more observations and flexible exchange rates (which could be include in the regression warning). Theoretical FrameworkIn position to comprehend the Dutch Disease theory, theoretical assume of tradable (T) and non- tradable goods4 (NT), besides cognise as the TNT Model can be used. According to Sachs and Larrain (1993) the most important assumptions is that N can neither be exported nor imported and its domestic inspiproportionn and toil must be equivalent. The opposite applies for T, aspiration and production domestically can differ because of the possibility of imports and exports T. In this specific pretense, two goods are produced and 4Page consumed T and N by one factor of productivity which is labor.The tack side obtains two linear functions QT = aTLT (T) and QN = aNLN (N), Where, production is dependent on labor. LT and LN accounts for the amount of labor used, whilst aT and aN are the marginal productivities of labor for the two sectors. In other words a T or aN units more of output is achieved if one extra unit of labor is applied in either sector. Due to the linear functions, aT and aN similarly 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. pending on T and N is expressed in the equation as followed A = PTCT + PNCN Total absorption is defined by A and trains of consumption for T and N by CT and CN. PT and PN correspond to the expenditure of the goods. Furthermore, Sachs and Larrain (1993) assume if the ratio CT/CN is fixed, therefore(prenominal) households consumes CT and CN in fixed proportions, (regardless of relative values). If overall spending increases, it is followed by an increase in consumption in T and N by the same proportion and vice versa. Figure 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 QT that is produced in order to produce the maximum quantity of QN. If QN = aNL then QT = 0, represented by point B in the figure. Then the factor of productivity labor is located in the N sector. If QN = 0 and QT = aTL, then labor is located in T (point D in the figure). The sky of the PPF is equal to PT/PN, 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, aN/aT = PT/PN = e. Figure The PPF, Consumption Path and Equilibrium QNCN B G H F C E D A 5Page QTCTEmpirical Findings and Analysis Data Summary of the Macroeconomic Variables used in the Regression Ratio of tradable goods to non- tradable goods (R) Sum of tradable goods (manufacturing care for added, agriculture value added) divided by the sum of non-tradable goods (services value added). Inflation as gross domestic product deflator in annual percent. Variables that are used to classify data into in return special categories. Here the dummy variable represent the spot 1975-1980, since the change in oil price was dramatic during these years. Based on current prices and is ex-pressed in USD per barrelUN (2010) Inflation (I) Dummy variable (D1) Nation get the hang Economy Statistics, U. A. E (historical data) (2010) Gujarati (2010) cost of oil (P) Annual Statistical bare OPEC (2010) Other variables were also tried and true, but over collectable to in remarkable values and to revoke problems of correlational statistics, some of the variables were excluded from the regression models. One of the other variables tested was money offer (M1), but since this variable was highly correlated with gross domestic product, we decided to exclude it. GDP was also excluded due to high correlation with the price of oil. Descriptive StatisticsThe pursuit figure shows the change in value added of tradable goods and non-tradable goods in U. A. E throughout the period 1975-2005 expressed in billion of AED per year. Value Added in Tradable and Non-tradable in U. A. E, 1975-2009 6Page Value (BAED) 350 300 250 200 150 one C 50 0 NT T As can be seen the production of non-tradable goods has been larger than tradable g oods (non-oil goods) during the entire period. The tradable sector has not in-creased as much as the non- tradable sector, i. e. non-oil production has decreased in comparison to non-tradable.In fact the non-tradable sector has increased almost twice as much as the tradable sector, which is a symptom of the Dutch Disease. One of the reasons why the non-tradable sector may have increased so much could be due to the country? s rise in export of oil throughout 1975-2009. US $ per pose 60 50 40 30 20 10 0 Price of Oil Inflation Rate Figure illustrates the birth amidst the price of oil and the inflation rate during the period 1975-2005. We will tolerate on analyzing the inflation rate? s peak and lows and the impact from the fluctuate oil price.We can first see that there was a curt decline in inflation from 19758 until 1978. During 1974 the inflation rate was 138. 26% check to Nation Master Economy Statistics (2010). The sharp decline could be due to that the U. A. E officially pe gged 7Page the AED to the USD in 1974. The fluctuation in the inflation rate cannot only be explained by a boom in production but also depends on other factors as well, such as the depreciation of the USD. One of the reasons why the inflation in U. A. E change so dramatically during the years 1998-2001 could be due to the burst of the I.T-bubble (known as the Dot-com bubble) in the late nineties which affected USD banly. The Regression Model In order to test if the chosen macroeconomic variables show indications of symptoms of the Dutch Disease, the model with the ratio of tradable goods to non-tradable goods was adopted but adjusted in order to fit this thesis. The adjusted equation is base on time series data. The presented macroeconomic variables inflation (I) is based on the theoretical framework presented, price of oil (P) is adopted which include price of oil in the regression analysis.The dummy variable (D1) for the period 1975-1980 is which included a dummy variable for a one year period. The ratio of tradable goods to non-tradable goods serves as the dependent variable in both models, however the independent variables differ slightly the first regression model includes inflation and price of oil as the independent variables. The second regression model also includes inflation and price of oil but a dummy variable for the period 1975-1980 was added. Model 1 R = ? 0 + ? 1P + ? 2I + ? Model 2 R = ? 0 + ? 1P + ? 2I + ? 3D1 + ? 4. 4. Econometric Problems In the beginning of the regression testing we discovered that some of the variables were correlated with one another. Money supply (M1) and GDP were the most correlated variables in the regression models, so in order to avoid multi co linearity problems we decided to exclude money supply and GDP from the regression model. The reason why the two variables were excluded was due to the high correlation between GDP and money supply and the high correlation between GDP and price of oil. Coefficient ?1 (Pric e of Oil) ?2 (Inflation) ?3 (Dummy Variable) . 5 Regression Results Sign negative or no solution negative negative or no effect 8Page In order to make it more comprehensive for the reader, the authors summarized the coefficients and significance levels (1%, 5% or 10%) from the two different regression model results with 36 observations for the period 1975 to 2010. The R-square values show that 39. 3% (model 1) and 75. 3% (model 2) of the change in the ratio of tradable goods to non-tradable goods can be explained by the model used. The goodness of fit in model 1 on the other hand, has a poorer fit, where 39. % of the influences on the dependent variable can be explained by the model. The better fit of model 2 can be due to the additional variable tested in the second regression model, i. e. D1. In model 1 and 2 the price of oil is significant and does not support the expectation that it would have a negative or no effect on the ratio. Price of oil is significant at a 1% significanc e level in model 1 and affects the dependent variable positively. A 1% increase in the ratio of tradable goods to non-tradable goods would increase the price of oil by 0. 05840%, all else equal. In the second regression model, the price of oil is significant at a 1% level, meaning that a 1% change in the regress and would increase the price of oil by 0. 002988%, all else equal. The results from the regression models indicate that the price of oil has a positive effect on the dependent variable. This result corresponds to the authors? expectations that during a boom in natural resources, inflation has a negative effect on the ratio. The negative relationship between the inflation rate and the ratio can also be xplained by the spending effect since in a fixed exchange rate regime the inflation rate is affected by the in-crease in the money supply. The second hypothesis for model one is therefore not rejected and the authors can conclude that the macroeconomic variable inflation is a s ymptom of the disease in the country. However in the second model the inflation variable is not significant and the authors can thereby not take the variable into consideration when analyzing if the U. A. E experienced the Dutch Disease during the years 1975- 1980.Furthermore, the insignificant value of the inflation rate in model two might be due to the short time period tested, 1975-1980. The major oil price shock during this period had a negative impact on the economy of U. A. E, which negatively affected the inflation rate, leading(a) to the insignificant-cant value in the second regression model. Time Series Regression Model 1 & 2 Model 1 R = ? 0 + ? 1P+ ? 2I + ? Coefficient Variable (t-stat) Constant 0. 166071*** (5. 141492) Price of Oil (P) 0. 005840*** (4. 122855) Inflation (I) -0. 352179* (-1. 38647) R2 = 0. 393393 DW = 0. 238252 *** monumental at 1% level ** Significant at 5% level * Significant at 10% level Model 2 R = ? 0 + ? 1P+ ? 2I + ?3D1 + ? Coefficient (t-stat) Co nstant Price of Oil (P) Inflation (I) Dummy Variable (D1) R2 = 0. 753809 DW = 0. 416614 0. 242127*** (10. 00689) 0. 002988*** (2. 915261) -0. 016530 (-0. 127760) 0. 144894*** (-6. 287065) 9Page Conclusions This project is a study whether the oil boom in U. A. E during the 1970s led to symptoms of the Dutch Disease and if the country is a victim of the disease.Three hypotheses were tested and descriptive data was analyzed in order to reach a conclusion. The first hypothesis tested the authors? asseveration that the price of oil has a negative (or no) effect on the ratio of tradable goods to non-tradable goods. The results showed that the price of oil did have a positive effect on the ratio, meaning that even though there are changes in the price of the natural resource it does not affect the production in the non-oil sectors to decline. guessing 1 is therefore rejected by us.In the mid-1980s the disease took an opposite direction when oil prices collapsed. Domestic demand dropped sharply in the oil-rich countries causing the construction industry to experience unemployment and employment shifted back to the tradable goods sectors. Therefore it can be concluded that the price of oil cannot be considered as a symptom of the Dutch Disease in the U. A. E. The second hypothesis was based on the problems of the high inflation rate U. A. E has experienced on and off during the years.Inflation was stated to have a negative effect on the ratio of tradable goods to non-tradable goods due to the fixed exchange rate. The regression results showed that inflation held a negative impact on the ratio therefore the hypo-thesis is not rejected by us. The last hypothesis was based on the high oil prices that existed during the period 1975-1980. Therefore a dummy variable was included in the hypothesis with the statement that it would have a negative (or no) effect on the ratio of tradable goods to non-tradable goods.Results showed that the dummy variable was negatively correla ted with the ratio, indeed the third hypothesis is not rejected. The negative relationship is in line with our expectations. One explanation for the negative impact on the ratio could be due to the oil price shock that occurred in 1979. The increase in the oil price during these years therefore affected the oil production negatively. Furthermore, the price of oil can be seen as a workable symptom of the Dutch Disease in U. A. E? s economy.