A Dutch disease approach into the premature deindustrialization

Abstract

We explore the main causes and consequences of the premature deindustrialization phenomena. We argue that local currency overvaluations mainly associated with a surge in capital inflows into the emerging market economies following the deregulation of their capital accounts severely hurt the output share of manufacturing industry. Applying the second generation estimators allowing for cross-section dependency (Augmented Mean Group and Common Correlated Effects Mean Group), we run a panel data regression model based on a sample of 39 developing countries in Latin America, Sub-Saharan Africa, East Asia, North America, and Europe from 1960 to 2017. We show that the baseline regression results are robust to different data sets, alternative real exchange rate/deindustrialization measurements, and dynamic model specifications. We find that an overvaluation of 50% which corresponds approximately to one and half standard deviations is associated with a contraction of manufacturing output share as high as 1,25% over the five year period. Moreover, the evidence suggests that the manufacturing competencies which have been eroded by local currency overvaluations in real terms cannot simply be brought back during the undervaluation periods. Hence, the need for a comprehensive industrial policy along with a firm use of capital controls and macroprudential measures given a robust institutional framework comes out as the main policy implication of our results, and they are duly discussed in light of recent developments in the literature.