In many ways, Brazil can be seen as the premier growth story so far in the new century.  The country has always been blessed with abundant mineral and agricultural resources.  What’s new is that it has finally been able to shake off the legacy of decades of economic mismanagement.  Brazil’s GDP now ranks it as one of the top ten economies in the world.

Brazil’s prosperity, and the resulting inflow of foreign capital, have caused commentators to worry that the country is suffering from “Dutch disease,” an economic challenge named after conditions in the Netherlands after discovery of massive offshore natural gas deposits there.

What is the “Dutch disease”?

It has two elements:

1.  a sharp rise in the exchange rate, as foreign money pours into the country to purchase output from existing mineral deposits and to own and develop new ones;

2.  severe problems in non-resource traded goods industries.   The higher exchange rate makes output more expensive, hence less attractive, to customers abroad, and the booming resource industry attracts capital and workers to it,  raising the cost of both for every domestic company.

Since when is an economic boom a problem?

Two reasons:

1.  the economy of a natural resources-driven country becomes hostage to the booms and busts of demand for its commodities;

2.  the country can end up with no advanced service or manufacturing industries of its own, to offset commodity downturns, or to be there when the deposits eventually run out.

What about Brazil?

The Netherlands is a tiny country.  Brazil has the sixth largest population on earth.  So having all the working-age population pulled into natural resource development isn’t an issue.

But the exchange rate is.  The real is up 36% against the dollar so far this year (the US is Brazil’s largest trading partner), and the country is awash in foreign currency inflows, both foreign direct investment and portfolio capital.

Brazil is concerned, as it should be.  It believes the portfolio inflows are primarily speculative, however, and has just instituted a 2% tax on them.  The tax doesn’t apply to Brazilian ADRs traded in the US, by the way–and will likely not have much effect, other than to set creative minds to work on ways to get around the levy.

The situation bears watching.

For non-resource industries in a “Dutch disease” country, the best solution is government subsidy to encourage increased productivity and innovation in industries hurt by currency appreciation.  Import barriers, which would constitute a return to the bad old days, are unlikely, I think, but still something to be on the alert for.

Should the flows reverse, I imagine Brazil would heave a sigh of relief and wave the money goodbye, even though the departures would cause short-term pain.  The only country in (my) recent memory to stop outflows with capital controls is Malaysia.  As I see it, that action has destroyed the country’s investment appeal to all but the most highly specialized portfolio investors since.