TCH: Dollarization in Ecuador

??????????? Some currencies are essentially abandoned when they become increasingly worthless due to hyperinflation. The public simply transitions to using foreign currencies instead. However, it’s also possible for a government to officially dispense with its own money and adopt that of another country as its official legal tender. Ecuador experienced a major economic crisis in the late-1990s. There were many causes but they included mismanagement of the old Ecuadorian currency, the sucre, and mismatches in the currency of bank assets and bank liabilities. So, replacing the old currency with the U.S. dollar seemed appealing insofar as it might prevent such problems from resurfacing again in the future.

Ecuador

??????????? In the 1990s, Ecuador attempted to open its economy to foreign trade and investment to solve the problem of slow growth, generally averaging just 2.5% per year, which is not particularly impressive for an emerging economy. The era also saw high inflation which had averaged 40% annually. This opening of the economy included a liberalization of the financial sector; deregulation saw bank reserve requirements reduced, for example. Bank deposits as a percentage of GDP grew from about 12% in 1990 to about 23% in 1998. This period also saw a lot of capital inflows from abroad.

??????????? By the end of the decade, slow economic growth, together with inflation and liquidity problems, afflicted Ecuadorian banks. Unfortunately, there was poor supervision of banks and bad business practices. Currency mismatches between their assets and liabilities meant depreciation of the Ecuadorian sucre was problematic for banks. Two banks failed in 1995-96. When the economy worsened later in the decade, loan delinquencies rose materially. The ratio of non-performing loans to total loans reached 57% and many more banks failed. Losses to banks and financial institutions reached $4 billion. In response, the government stepped in to guarantee deposits.

??????????? Falling oil prices in 1997 and 1998 hurt the economy as Ecuador is a minor oil producing country. Further, El Ni?o caused climate-related disruption to the economy in 1998, hurting agricultural exports. In 1999, unemployment reached 14.4% and underemployment stood at 58.5%. There was social unrest and general strikes.

??????????? Solutions to the economic and banking problems involved printing money. Devaluations became more severe after 1998. Inflation rose from an annual average of around 40% to approximately 100% between 1998 and 2000. There was also the problem of growing public deficits and debt. Ecuadorian debt grew from 67% to 100% of GDP between just 1998 and 1999 and the external debt specifically grew from 47% to 70% over the same period. Because of other difficulties in Latin America and Asia, financial markets were increasingly nervous about financing emerging market countries. Lack of faith in the public finances meant spreads on Ecuadorian government bonds were in excess of 40%.

???????????Capital outflows reached $2 billion, or 10% of GDP, in 1999. Bank credit peaked that same year, and began to decline just as swiftly as it rose. In February 1999, the Ecuadorian sucre was devalued further. Bank deposits were frozen in March and the government defaulted on its debt in September.

Dollarization

??????????? Panama already used the U.S. dollar as its official currency, as it had since 1904. But the U.S. dollar was in use there since the country’s independence. By contrast, Ecuador would become the first country to abolish its own currency completely, in order to adopt the dollar exclusively. During the 1990s, having a convincing link to the dollar was something that set countries apart. Mexico and various Asian countries experienced currency crises during the decade. Most of the afflicted countries devalued and those whose currencies remained linked to the dollar nonetheless saw their economies suffer from the uncertainty around whether such exchange rates could be maintained. Still, the latter generally performed better.

???????????Ecuador’s president since 1998 was Jamil Mahuad. Amidst the economic crisis, he announced in January 2000 that the country would dollarize, in the last days of his government. This did not immediately end the crisis. He was replaced within days by vice president Gustavo Noboa, who continued the policy and kept Ecuador’s congress and central bank on board. The move was accompanied by other economic reforms including incentives for private investment, privatizations, and increasing flexibility in labor market. Banks were examined and most of the weakest banks were closed. The government also obtained support from the International Monetary Fund.

??????????? The exchange rate between the old currency and the U.S. dollar was set at 25,000 sucres per dollar. Over several months, sucres were repurchased by the government and bank account balances were converted to dollars and unfrozen. Perhaps surprisingly, the unfreezing did not trigger any bank run. Official adoption of the U.S. dollar as Ecuador’s currency came in September 2000.

Costs

??????????? One cost of dollarization is that such a decision is difficult to reverse, unlike simply pegging one currency to another. Giving up an ability to print money means a state loses seigniorage, the profits from printing money, as a revenue source.

???????????Though, if people are accustomed to using dollars in their savings and trade, making demand for local currency low, then seigniorage revenues are likely to have been low anyway. In Ecuador, around 74% of exports were already denominated in dollars in the late 1990s. After the freeze of bank accounts, Ecuadorians began saving more abroad; offshore deposits grew by $755 million in 1999. About 39% of bank deposits and 52% of loans were already U.S. dollar denominated by 1999. So, the local currency was already sharing the role of money with the U.S. dollar. Still, Ecuador had to bear the cost of converting old banknotes and coins into dollars by exchanging the former for the latter.

??????????? Giving up the sucre meant there was no possibility of devaluing the currency any more. So, the potential to devalue in order to promote exports was lost as a policy option. An inability to print money also limited the government or central bank’s ability to respond to crises, which could create more instability. For example, if the government could not print money to rescue failing banks, then bank runs could become frequent. Nonetheless, excessive inflation was part of the problem in Ecuador and the economy began to recover in 2000 without the need to print more money.

Benefits

??????????? The irreversibility of the policy may be a positive. Dollarization fostered creditability among investors. No chance of devaluation means borrowing costs can be lower for a developing country’s government and its private borrowers alike. Dollarization reduces the interest rate spread that emerging market borrowers experience because of the risk of devaluation. Dollarization may also reduce credit risk because borrowing countries are not inclined to borrow money in foreign currencies in order to defend the value of their own currency, as Mexico did in 1994, if they are dollarized. This activity weakened Mexico fiscally.

??????????? Shortly before the implementation of the U.S. dollar was finalized, spreads on Ecuadorian government bonds fell sharply from astronomical 40%+ levels during the crisis to 10-20%. The debt was restructured in August 2000, as dollarization was being introduced so its difficult to isolate the effect of the latter. Still, to the extent that dollarization reduced the currency risk of lending to Ecuador, dollarization played a part.

??????????? One might expect integration with the large U.S. economy as a result of adopting its currency. However, this did not pan out for Ecuador which saw its trade with the U.S. grow only modestly, though because Peru and Colombia had free-trade deals with the U.S. and Ecuador did not, this may have been the result of competition from these countries.

??????????? More importantly though, high inflation ceased to be a major problem in Ecuador for while inflation was still high in the first year after the transition, it fell to 7.9% in 2003, the first year since 1972 in which inflation stood below 10.0%. By 2004, inflation had converged to U.S. levels and has more-or-less remained at U.S. levels since. Dollarization inspires confidence in an economy if investors think that the local currency was not being well managed. Although, since Ecuador is not recognized as accommodating of foreign investors in other respects, the gains here have been limited.

??????????? So, since dollarization, inflation has remained low and there are no more devaluations. Public borrowing costs fell to fairly normal levels. Helping matters, Ecuador’s public debt burden fell in the years after dollarization. Also, for at least a few years, the economy grew markedly quicker. GDP growth averaged 3.9% per year between 2000 and 2010, much stronger than before.

Lesson

??????????? Ecuador’s experience shows that unofficial dollarization is possible. People may dollarize themselves without official change in policy by voluntarily holding foreign currencies and using them in transactions, including in financial transactions. Ecuador had a moderately dollarized economy even before 2000. Nonetheless, official dollarization arrived and brought some noteworthy benefits. Still, it is not a cure-all. Ecuador imposed pro-growth reforms and curtailed fiscal excesses more-or-less simultaneously with dollarization and these changes were no doubt important, likely even more important. Also, to the extent the country remains a less-than-easy place to do business, the country is still held back regardless of dollarization.

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Further Reading

1.????? Borensztein, Eduardo, and Andrew Berg. “The Pros and Cons of Full Dollarization.” IMF Working Paper, vol. 00, no. 50, Jan. 2000.

2.????? Mahuad, Velasco, & Rubio Marquez. “How We Dollarized Ecuador.” LSE School of Public Policy, 8 June 2022.

3.????? Ozyurt, Selin, and Simon Cueva. “Twenty years of official dollarization in Ecuador: a blessing or a curse?” Macroeconomics & Development, vol. 31, July 2020.

4.????? Quispe-Agnoli, Myriam, and Elena Whisler. “Official Dollarization and the Banking System in Ecuador and El Salvador.” Economic Review, Federal Reserve Bank of Atlanta, vol. 91, no. 3, pp. 55–71.