A country is said to suffer from the Dutch Disease when booming demand for its commodity exports starts to fade.
Initially, rapidly increasing commodity demand (for example from the emerging markets) create a larger trade surplus. This leads to a fast rise in demand for its currency. At first sight, the result is an economic boom, but there is also an adverse effect that may not be obvious in the short run. As the country’s currency strengthens, the domestic sectors that are not related to commodities, but that do have to compete with foreign firms, are becoming less competitive. That is, as their products become more expensive abroad, demand fades. In addition, the value of foreign products denominated in domestic currency goes down. This toughens competition for domestic, import-competing firms.
Thereby, although the commodity sector is booming, other sectors are facing ever stronger headwinds. What adds to the pressure is that the demand for labor in the commodity sector pushes up wage costs, but also for the sectors that are not directly benefiting from the commodity boom. As their costs and competitive pressure rise, a “hollowing out” of the domestic sector takes place.
The negative effects of this become increasingly visible, when these sectors have been so strained that investment and therefore productivity starts to lag.
When the commodity boom fades, this also lays bare the vulnerabilities in the non-commodity-related sectors. The larger the commodity boom, and the more this supported a credit bubble (possibly also a housing market bubble), the larger the damage will ultimately be.