An Assessment of Dollarization in Ecuador
It’s been over five years since the Ecuadorian government, in an attempt to restore stability to its shattered economy, officially made the decision to abandon the hyper-inflated Sucre and adopt the US dollar as the nation’s official currency. This policy brief aims to review the case for dollarization in Ecuador, assess if the policy decision has delivered the expected results, review the advantages and challenges posed by a dollarized economy (within the Ecuadorian context) and propose a set of recommendations.
After a very severe crisis in 1999, Ecuador adopted dollarization. Even though the country had reached a more or less consistent management of the nominal exchange rate since 1993, this reversed in 1997 and 1998 when the economy was shaken by a series of external shocks. Extensive damage to agriculture and infrastructure by El Nino, a vast fall in oil prices (Ecuador being a net oil exporter), the sudden stop provoked by the Russian crisis and the recession in international markets after both Russian and Asian financial crises. These shocks led to a deterioration of fiscal deficit, bank insolvency and runs on deposits and a strong pressure for devaluation.
The (spontaneous) semi-dollarization that had taken place in Ecuador during the crawling peg exchange rate regime (substantial portion of private assets and liabilities were held in dollars) exacerbated the effects of the 1998 shock-led devaluation as the currency mismatch –the banks had substantial dollar denominated loans that were not backed up with dollar income– increased non-performing loans and strangled even more the banking system. The Central Bank had to provide banks with massive liquidity support throughout 1999. Late in the year, the depletion of international reserves resulting from the monetary issue led to an exchange-rate collapse and early hyperinflation. After losing its ability to control the money supply and, hence, the value of the Sucre, and in the midst of a systemic financial crisis the government was forced to dollarize the economy in order to halt the rapid depreciation, control hyperinflation and stabilize the economy.
Official dollarization occurs when a country adopts a foreign currency as legal tender. In the Ecuadorian case, the decision was to use the US dollar as their predominant currency (25,000Sucre = US$1). By doing so, they surrendered their monetary sovereignty and linked their inflation rate to US monetary policy. In return, dollarization should preclude the government from using inflation as a revenue source, which enhances soundness and transparency of monetary policy. This in turn shall improve the prospect for real economic growth.
Was dollarization inevitable? Given the scale of both the currency and systemic banking crisis that broke out during 1999 coupled with the country’s institutional and political weakness, dollarization seems to have been an unavoidable measure. The step to dollarization was a bold move to reverse hyperinflation and capital flight. In reality, Ecuador gave up an active monetary policy that had proved ineffective and, even more, disruptive. From a traditional view in which dollarization must be implemented only under a stable set of macroeconomic conditions and sound institutions, dollarization in Ecuador was predicted to be a failure. However, the scheme worked well as a last resort response to an inexorable systemic crisis and, notwithstanding the institutional and political weaknesses, it was successful in reaching the desired stabilization and transparency objectives. In this sense, dollarization was a good and perhaps the sole alternative to curb fiscal imbalances and to restrain the government’s spending patterns.
Given the degree of “informal” financial dollarization of the Ecuadorian, this dual account system prevented other policy responses from being effective to stop the crisis. The increase in interest rates required to mop up liquidity and reduce devaluation pressures would have been so high that it would have asphyxiated the financial system. More preventive actions however, may have had reduced the need for dollarizing. For instance, the government failed to tighten its fiscal policy and adjust the fiscal imbalances before and during the crisis. Additionally, some of the policies adopted by the authorities aggravated the situation, in particular charging a tax on financial transactions (1%) in the midst of the crisis increased banking insolvency; additionally. setting a universal guarantee on deposits was ineffective, its credibility was quickly undermined by the government’s manifest inability to pay.
The dollarization scheme seems to have been successful, especially with respect to its original purpose of reducing inflation and creating more favorable conditions for economic growth. Since dollarization, the Ecuadorian economy, which contracted by 7.3% in 1999, has experienced growth of 2.8% in 2000; 5.1% in 2001; 3.4% in 2000; 2.7% in 2003; and a booming 5.4% in 2004 . However, around 2/3 of this growth comes from oil revenues (oil constitutes 40% of Ecuador’s revenues) which indicates that the country has also profited from the betterment in terms of trade.
There has been a rapid recovery of the relative prices and the stability of the price level and inflation following the crisis and recovery, which is apparently due to the move to dollarization. Inflation, once a serious problem for the Ecuadorian economy, has declined from an annual rate of 96.1% in 2000 to 2.7% in 2004. The current reduction in inflation will contribute in offsetting the loss in competitiveness of exports since the implementation of dollarization. However, competitiveness is still an issue and a dollar appreciation could reduce the country’s trade balance. Although Ecuador’s main trading partner is the United States, with 42% of exports, the dollar exchange rate of other major trading partners such as Colombia (12% of exports) and Chile (6% of exports) may put pressures to the Ecuadorian economy to reduce wages and prices in order to sustain competitiveness. There has been evidence, although anecdotal, of companies migrating production to Colombia and Peru, where costs are lower.
One of the main benefits of dollarization is a decrease in risk premium on a country’s international debt, given the elimination of the risk posed by high exchange rate volatility. However, Ecuador has not been able to take advantage of this benefit given its substantial default risk. External public debt has come down from 54% of GDP in October 2002 to 38.7% in April 2004. Strict budgets are required under dollarization given that the government can’t print dollars to finance deficits. This has been positive for Ecuador, given its loose institutional arrangements and its weak and patrimonial political structure.
De-dollarizing the Ecuadorian economy would be extremely difficult and may not be done without substantial costs. One of the major benefits of dollarization is that it derives credibility from the perception that it is permanent. The sole announcement of a formal de-dollarization without a credible alternative –as seems to be the case in Bulgaria as they will be adopting another hard currency (the Euro)- may bring about a self-fulfilling crisis. Additionally, a formal de-dollarization would leave the Ecuadorian economy largely de facto dollarized (analogous to the pre-crisis situation) and vulnerable to the dual account system and currency mismatches.
How resilient is dollarization? To sustain dollarization the country has become largely dependent on multilateral support given that it has not had access to the financial market since the default on Brady Bonds in 1999. Additionally, given that government spending continues to be high on state subsidies, state salaries and pensions, there is a lack of funds available to serve these commitments. This can convey the risk of increased social pressures for de-dollarization. More importantly, dollarization per se will not set the conditions for economic growth to materialize. The sustainability of dollarization in the long run will depend on the ability of the country’s ability to adopt several structural reforms that are needed to sustain economic growth. Particularly, reforms are needed in the labor and product markets to improve competitiveness, in the government structure to reduce fiscal imbalances and increased regulation and supervision to produce a safe and efficient financial system.
After a very severe crisis in 1999, Ecuador adopted dollarization. Even though the country had reached a more or less consistent management of the nominal exchange rate since 1993, this reversed in 1997 and 1998 when the economy was shaken by a series of external shocks. Extensive damage to agriculture and infrastructure by El Nino, a vast fall in oil prices (Ecuador being a net oil exporter), the sudden stop provoked by the Russian crisis and the recession in international markets after both Russian and Asian financial crises. These shocks led to a deterioration of fiscal deficit, bank insolvency and runs on deposits and a strong pressure for devaluation.
The (spontaneous) semi-dollarization that had taken place in Ecuador during the crawling peg exchange rate regime (substantial portion of private assets and liabilities were held in dollars) exacerbated the effects of the 1998 shock-led devaluation as the currency mismatch –the banks had substantial dollar denominated loans that were not backed up with dollar income– increased non-performing loans and strangled even more the banking system. The Central Bank had to provide banks with massive liquidity support throughout 1999. Late in the year, the depletion of international reserves resulting from the monetary issue led to an exchange-rate collapse and early hyperinflation. After losing its ability to control the money supply and, hence, the value of the Sucre, and in the midst of a systemic financial crisis the government was forced to dollarize the economy in order to halt the rapid depreciation, control hyperinflation and stabilize the economy.
Official dollarization occurs when a country adopts a foreign currency as legal tender. In the Ecuadorian case, the decision was to use the US dollar as their predominant currency (25,000Sucre = US$1). By doing so, they surrendered their monetary sovereignty and linked their inflation rate to US monetary policy. In return, dollarization should preclude the government from using inflation as a revenue source, which enhances soundness and transparency of monetary policy. This in turn shall improve the prospect for real economic growth.
Was dollarization inevitable? Given the scale of both the currency and systemic banking crisis that broke out during 1999 coupled with the country’s institutional and political weakness, dollarization seems to have been an unavoidable measure. The step to dollarization was a bold move to reverse hyperinflation and capital flight. In reality, Ecuador gave up an active monetary policy that had proved ineffective and, even more, disruptive. From a traditional view in which dollarization must be implemented only under a stable set of macroeconomic conditions and sound institutions, dollarization in Ecuador was predicted to be a failure. However, the scheme worked well as a last resort response to an inexorable systemic crisis and, notwithstanding the institutional and political weaknesses, it was successful in reaching the desired stabilization and transparency objectives. In this sense, dollarization was a good and perhaps the sole alternative to curb fiscal imbalances and to restrain the government’s spending patterns.
Given the degree of “informal” financial dollarization of the Ecuadorian, this dual account system prevented other policy responses from being effective to stop the crisis. The increase in interest rates required to mop up liquidity and reduce devaluation pressures would have been so high that it would have asphyxiated the financial system. More preventive actions however, may have had reduced the need for dollarizing. For instance, the government failed to tighten its fiscal policy and adjust the fiscal imbalances before and during the crisis. Additionally, some of the policies adopted by the authorities aggravated the situation, in particular charging a tax on financial transactions (1%) in the midst of the crisis increased banking insolvency; additionally. setting a universal guarantee on deposits was ineffective, its credibility was quickly undermined by the government’s manifest inability to pay.
The dollarization scheme seems to have been successful, especially with respect to its original purpose of reducing inflation and creating more favorable conditions for economic growth. Since dollarization, the Ecuadorian economy, which contracted by 7.3% in 1999, has experienced growth of 2.8% in 2000; 5.1% in 2001; 3.4% in 2000; 2.7% in 2003; and a booming 5.4% in 2004 . However, around 2/3 of this growth comes from oil revenues (oil constitutes 40% of Ecuador’s revenues) which indicates that the country has also profited from the betterment in terms of trade.
There has been a rapid recovery of the relative prices and the stability of the price level and inflation following the crisis and recovery, which is apparently due to the move to dollarization. Inflation, once a serious problem for the Ecuadorian economy, has declined from an annual rate of 96.1% in 2000 to 2.7% in 2004. The current reduction in inflation will contribute in offsetting the loss in competitiveness of exports since the implementation of dollarization. However, competitiveness is still an issue and a dollar appreciation could reduce the country’s trade balance. Although Ecuador’s main trading partner is the United States, with 42% of exports, the dollar exchange rate of other major trading partners such as Colombia (12% of exports) and Chile (6% of exports) may put pressures to the Ecuadorian economy to reduce wages and prices in order to sustain competitiveness. There has been evidence, although anecdotal, of companies migrating production to Colombia and Peru, where costs are lower.
One of the main benefits of dollarization is a decrease in risk premium on a country’s international debt, given the elimination of the risk posed by high exchange rate volatility. However, Ecuador has not been able to take advantage of this benefit given its substantial default risk. External public debt has come down from 54% of GDP in October 2002 to 38.7% in April 2004. Strict budgets are required under dollarization given that the government can’t print dollars to finance deficits. This has been positive for Ecuador, given its loose institutional arrangements and its weak and patrimonial political structure.
De-dollarizing the Ecuadorian economy would be extremely difficult and may not be done without substantial costs. One of the major benefits of dollarization is that it derives credibility from the perception that it is permanent. The sole announcement of a formal de-dollarization without a credible alternative –as seems to be the case in Bulgaria as they will be adopting another hard currency (the Euro)- may bring about a self-fulfilling crisis. Additionally, a formal de-dollarization would leave the Ecuadorian economy largely de facto dollarized (analogous to the pre-crisis situation) and vulnerable to the dual account system and currency mismatches.
How resilient is dollarization? To sustain dollarization the country has become largely dependent on multilateral support given that it has not had access to the financial market since the default on Brady Bonds in 1999. Additionally, given that government spending continues to be high on state subsidies, state salaries and pensions, there is a lack of funds available to serve these commitments. This can convey the risk of increased social pressures for de-dollarization. More importantly, dollarization per se will not set the conditions for economic growth to materialize. The sustainability of dollarization in the long run will depend on the ability of the country’s ability to adopt several structural reforms that are needed to sustain economic growth. Particularly, reforms are needed in the labor and product markets to improve competitiveness, in the government structure to reduce fiscal imbalances and increased regulation and supervision to produce a safe and efficient financial system.
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