Dollarization in Ecuador

A brief review of Ecuador's economic situation in the two years prior to dollarization

The continuing inflation, the currency depreciation and the constant instability have led to a permanent discussion about the role of the Central Bank and the most proper type of exchange rate. In the last 20 years almost every single exchange type has been tried in order to finance the state deficit. This topic could be very interesting, but it does not represent the essence of development, which is more and better work for everybody.

The first part will narrate the economic situation of Ecuador in the two years prior dollarization in 10 sections.

But first let's review the economical data of 1998 (our starting point)

• State international debt: 13000 million dollars, which was the 64% of the GDP. (www.bec.fin.ec)

• State internal debt: 1000 million dollars. (www.bec.fin.ec)

• Debt to the social security system on the future demands of its “clients”: 7000 million dollars (www.bec.fin.ec)

• Debt of companies and natural persons to the private financial system: 7000 million dollars, of which 30% was in sucres. (www.bec.fin.ec)

1 Part

The government lost a great factor of its budget due to the price decrease of petroleum. The state approved modest budget cuts in order to increase the income, while the total expenditure continued to rise greatly. The private financial system started to feel an enormous pressure due to the high interests rates imposed by the government in order to take the resources of the market.

The consequences of this issue were an increase of the interest rates once the capability of payment of the market decreased. The banks started to feel serious tribulations. (www.elcomercio.com)

2 Part

By the end of this year “El nino” brought grave production problems to the exporters of several primary products. A few months after, the international crisis stroke the already weak export sector. This represented a new hit to the banks and the trust. (www.elcomercio.com)

3 Part

The banks found themselves in an inevitable future bankruptcy.

4 Part

The first bank went bankrupt (Filanbanco). This problem brought several negative consequences.

First, there was a monetary disorder. The Central Bank gave this entity 600 million dollars. At this moment the war against the sucre began.

The Central Bank tried to maintain the value of the sucre by selling dollars of the international monetary reserve, which continued to get smaller.

Second, the government said that it was willing to save every single Bank. With this resolution, the bankers felt that they could save their “wealth” by translating their problems to the society.

Finally the people perceived that the bankers would not accept the responsibility of their misfortune. In the worst case they would lose the property of their institutions, which was almost zero anyway. They would never accept the responsibility for their clients.

The mistrust in society increased at an uncontrollable level. (www.elcomercio.com)

Part 5

In February, the Central Bank declared the free flow of the sucre. There is no advantage in using the international reserve in order to prevent the sucre to decrease its value.

The exchange rate sucre-dollars doubled in a few days.

In March other banks went bankrupt. The regime imposed a law that disabled the public to take their capital out of their bank accounts (The “Frozen” accounts).

This mechanism prevented the value of the sucre from decreasing even further and more banks from losing total solvency.

These circumstances were the main reasons that lead to a deterioration of the economy, not only for its direct monetary impact, but for its lethal strike to the trust of the public on the system. It was known that there were arrangements between the government and the bankers. (www.elcomercio.com)

Part 6

Although the accounts were “frozen”, the banks still were in serious solvency problems, because the indebted found themselves with less capacity to pay their debts. The Central Bank still played the role of sponsor of misfortune.

The International consulting firms concluded that four more Banks were in intensive therapy. Once again the Central Bank increased the interest rates in order to prevent the devaluation of the sucre. This made the debts even more unpayable.

Those indebted in sucres could not pay their credits anymore due to the high interest rates. Those indebted in dollars found themselves in serious jeopardy, because the devaluation made their payments go up and their income did not rise in the same manner. (www.elcomercio.com)

Part 7

The result of all of this made the market shrink. The size of the “pie” (GDP) reduced from 20 billion dollars to 14 billion dollars in 1999.

This shrink represents more unemployment and a significant loss of acquisition power. The economy drowned due to the lack of capital and more Ecuadorians sent their money to off shore accounts. (www.elcomercio.com)

Part 8

Due to all of these circumstances, the government found itself in a dead end, in spite of the fact that the price of petroleum increased considerably. Because of this, the regime announced that it was no longer capable of paying the Brady Bonds (international debt). This was the finishing hit to international trust. (www.elcomercio.com)

Part 9

The transition between 1999 and 2000 determined an out of control devaluation. The exchange rate, sucres-dollars, increased from 16,000 sucres to 20,000 sucres in just a few weeks, and then from 20,000 sucres to 26,000 in a few days. The inflation went up to 100% annually. The hyperinflation was at this moment just around the corner.

The administration was at a point of no return, because the negotiation with the International Monetary, which was the last option Ecuador had, continued to be stuck.

Moreover, the social and political parties started to put a great amount of pressure on the command.

Finally the command, which no longer had any alternatives or options decided to dollarized the country.

At the end of this period the government was overthrown by the parlament. (www.elcomercio.com)

Part 10

With this scenario dollarization began.

Although we have seen several economic issues, which led Ecuador to an imminent dollarization (or to a hyperinflation), we still have to question the real motives of the government in applying this new monetary structure. It is my believe that the government never analyze the social and economical future consequences of dollarization (for good or for bad), it used dollarization as a salvation policy. Before dollarizing the country, it faced itself against social movements that had one determined goal, replacing the administration with a popular government. Most of the sectors in Ecuador blamed the regime for the inflation, which would have led Ecuador to a ruinous standard of living. The people also blamed the government for being more connected to the interests of powerful groups (bankers, politicians) than the common basic demands of society. By this time several leaders of popular groups claimed that dollarization could bring Ecuador a needed stability.

Once the fall of the government was unavoidable, the regime dictated dollarization as the new economical policy in order to satisfy the wants of the people so that it could stay in the power.

The role of the Central Bank

The Central Bank should increase the exact amount of money supply in order to maintain the productive apparatus, without too many fluctuations. The quantity of money supply should be related to growth of the economy, 3% or 6 % for an economy like the Ecuadorian. The money supply should be around 8% or 10%, with this rate between 3% and 5% it could finance inflation and 3% or 6% could finance economical growth.

The Central Bank also has to decide which exchange rate type to use in order to accomplish these goals. There are two types that the Central Bank could use:

-Fixed exchange rate: With this type the Central Bank could control the inflation in an optimal way but it would have less freedom in its monetary decisions. In effect if it tries to increase the money supply (to finance banks or the government) the interest rates tend to fall, the people send their money to other countries with higher interest rates and this leads to an increase in the exchange rates.

Now the Central Bank has to sell the dollars in its reserves (it compromised to maintain a fixed exchange rate) and take the sucres out of the economy. The result was a stable exchange rate but it lost part of its reserves. (James Hanson)

-Flexible exchange rate: With this exchange rate type, the Central Bank has monetary freedom but the economy could have inflation problems. If it tries to increase the money supply (to finance banks or the government) the interest rates tend to fall, the people send their money to another countries with higher interest rates. This also leads to an increase in the exchange rates and the price levels increase. (James Hanson)

Not good results

In the industrial countries, especially the United States, the performance of the Central Bank in the past 15 years has been positive. It has maintained an economical growth and the annual inflation has been below 5%. In the same manner, the German Central Bank has achieved remarkable results. However not every country has had the same prosperity, Japan, for instance, has found itself in a solvency trap. The Central Bank injected money into the system and the interest rates went down to incredibly low levels (loans at 3% annual). But the economy did not seem to wake up. People did not want to get indebted, because they did not know if they would have a job in the future in order to pay their debts. The citizens did not spend on assets, because they thought that the prices could go down and it would be better to wait.

In the 70's there was inflation in the United States due to the Vietnam War and there also inflation in the 80's due to the high price of oil. Since then the U.S has resolve its financial issues in an optimal way, but there is uncertainty for future. And the question still remains: Is the U.S Central Bank or the dynamic of the economical agents keeping the finances stable? Today there are remaining doubts of the capability of the Central Bank to influence the economy in a positive way.

In contrast, the results in several developing countries, especially the ones in Latin America, have been catastrophic.

Since the late 70's to the early 90's, most Latin countries experienced hyperinflation (1000%, 5000% and 10000% annual), with the exception of Paraguay, Colombia and Ecuador. (Cordeiro)

The bank system and the new role of the Central Bank

Although Ecuador has dollarized, the Central Bank of Ecuador does not have to disappear. The only function that the Central Bank will no longer has is the creation of money. This means that the Central Bank does not have the power to resolve the problems of certain groups. Another function that would vanish is the establishment of the exchange rate.

Ecuador will now depend on the monetary and exchange rate type policies of Federal Reserve of the U.S.. Without a doubt, the U.S Central Bank could face similar issues as the Ecuadorian Central Bank did. However historically the Federal Reserve has managed the finances and the economy in a responsible manner. Ecuador has to trust that this U.S entity will use the same measures that it has been using so far for its own benefit.

Now the Ecuadorian Central Bank (C.B.) will have to focus on the following functions:

Operational area

The C.B will keep administering operational aspects such as the compensations chamber between banks (checks fluctuations). It also has to run the external operations for the government. Additionally the C.B has to change all the remaining sucres into dollars (Yes, there still are sucres in the economy). Finally it has to control the emissions of the new Ecuadorian coins. (Paredes)

I have not found any economical opinions or data about the fact that Ecuador will create their own coins with the same value as U.S coins. But, it is my believe that having Ecuadorian coins would be beneficial for the cultural factor. It seems that being familiar with historical characters shown in the currency will improve the pride of the Ecuadorian people.

On the other hand it is also my opinion that the C.B could have some monetary freedom with the creation of coins. The C.B could create a money supply with the coins but at the same time it could not create an excessive money supply because of the cost of production. This way a possible inflation would be discarded, the C.B would have to produce just enough.

Banking area

The C.B kept the power to impose a solvency limit to the Banks. This means that the C.B obligates the private Banks to have a certain quantity of reserves for possible future problems. The C.B could fuse with the Intendancy of Banks (entity that controls the private banks) in order to optimize resources. (Paredes, Cordeiro)

Reserve funds

The financial system could prevent solvency problems generated by external or domestic shocks. Because of this reason, the C.B should take precautions with the reserves they have ( 70 million) for difficult times. The use of these resources is fundamental to assure the banks stability. (Paredes, Cordeiro)

The last two functions are indeed polemic. Not everybody agrees that the C.B continues to have a monetary role.

For instance radical dollarization supporters maintain that the Ecuadorian banks should interact more with international banks. The individual banks should establish a reserve, which they think could be enough for times of depression. In cases of low solvency they should look for resources in foreign markets instead of asking the C.B for aid. We know that the C.B has made some terrible mistakes but is the international finance market perfect?

Besides the C.B will be easier on the private banks, because it always looks for the well-being of the Ecuadorian society. In contrast, international banks are always looking to make profits.

When the Mexican depression hit the banks in Argentina, the government had to give 20 billion dollars to them, in order to provide some oxygen to the economy, because those banks could not find any resources in foreign markets.

However the C.B should not make the same mistakes it did before, it should be more responsible with the resources. Another strike to the economy could be catastrophic.

There are 3 main concepts that the financial system should be awarded of:

*More integration with international banks

*More and better public information about the quality of the financial system

*Efficient, strict and non-political supervision

The Central Bank in a dollarized economy

We have seen that the C.B no longer has monetary production power. If the C.B needs to give aid to the government, banks or the private sector with state resources, the regime will have to increase taxes or get indebted. This possible situation could be very hard for the country.

More easily, it could print more bills, give aid, generate inflation and problem solve. Nevertheless we have to realize that in any case, the resources will come from the citizens. In the case of inflation, the people who have less money will be more affected. In the case of debt, the resources will come from the taxpayers, which represents more equity.

Definition of seniorage

So far we have seen that the Central Banks in the world have increased the money supply in a higher percentage than the demand for money requires. But I ask myself; does not the C.B know that increasing the money supply causes inflation and other negative consequences? However, the fact is that the C.B does know that an “extra” money supply could have those consequences. The reasons could be an expansive monetary policy (which is understandable in the short term) or trying to finance the state.

The last reason is named the seniorage. The seniorage is the possibility that the government finances itself or finances what it considers necessary via bills printing. It is just the matter of ordering printing of bills. (Paredes, Cordeiro)

Somehow a truly independent C.B has the faculty to avoid the government from doing the seniorage. But in Ecuador powerful groups have always manipulated the C.B, in spite that the law gives the C.B complete autonomy. The people can defend themselves against the seniorage by not using the local currency and using another, but just the people who have more information and resources could do that and the rest would remained unprotected.

Seniorage or inflation tax

The seniorage could solve some misfortunes of the government. But there are no miracles in economics; we must see the other side of the coin.

For instance the money increases in 50% (money supply) while the GDP increases in 5% or 6%, automatically there will be inflation. Inflation reduces the acquisition power of the bills. The government pays its contractors and employees in sucres bills, but at the end of the year these bills have lost 50% of their value.

Seniorage generates inflation taxes. We call it a tax because of its characteristics. On one side it generates income to the state, via seniorage. On the other side the citizens are paying the government via inflation. It is an indirect tax because it is difficult to notice and just the individuals who have the information and resources could in someway avoid it. (Paredes, Cordeiro)

The seniorage could be considered as the monetary creation of the C.B and inflation tax is the inflation rate. When the growth of money supply equals the inflation, seniorage and inflation tax are the same.

With dollarization the regime will lose its seniorage but at the same time the persons will stop paying the inflation tax. Instead of seniorage the administration should charge another tax, that more fair and clear than the inflation tax.

The U.S could compensate its seniorage

The U.S government obtains the income of seniorage as any other country, it sells its bonds to the Federal Reserve and it receives dollars in exchange. The difference between Ecuador and the U.S relies in the fact that the U.S has done it responsibly. That is the reason why the U.S has a low inflation rate.

Not only the U.S citizens pay this tax but everybody that has dollars. In fact, it is approximated that 60% of the dollars circulate in the rest of the world. This means that the U.S government is receiving 60% of its inflation tax from non-U.S citizens.

On the other hand, a bill exists, which is being discussed in the U.S Senate to facilitate the process of dollarization in other countries. The purpose of this law is to give some of the seniorage that the U.S receives to countries that are officially dollarized.

Ecuador could receive an amount between 50 and 100 millions dollars. In addition some proposals state that U.S should give the seniorage amount for 20 years to countries like Ecuador in advance. (www.elcomercio.com)

However this law has a lot of opposition, because the U.S is afraid that the Federal Reserve could be pressured by dollarized countries to establish a law that will benefit other countries and not only the States. Additionally giving 60% of its seniorage income could represent great amounts, way too high perhaps.

It is my opinion, that the U.S is willing to compensate other countries for its seniorage not only because they think its fair (which it is). Also they think it is beneficial to have the dollar expand among countries, because the U.S makes the dollars, which means that it would have monetary power on these countries.

External shocks and devaluation

One of the consequences of an external shock is less quantity of dollars available in the country. This situation could happen due to several reasons (e.g. like more imports and less exports). It is a circumstance that hits the economy and a citizen can visualize it by looking at the reduction of the GDP.

In a flexible system, governments devaluate the currency to solve the problem. The main reason to execute this policy is to give more rent ability to the exporters and reduce the value of imported goods. This condition will lead to a higher accessibility of dollars in the market and fewer dollars spent.

However, we have to become conscious of the fact that a shock with or without devaluation will make people poorer. The salaries and the internal prices in dollars have reduced, which allows the exporters to earn more. The people will also be forced to work more to buy imported goods, which have become more expensive due to devaluation. Additionally, in a semi-dollarized economy, such as the Ecuadorian (before dollarization), devaluation has another negative effect. Debts in dollars will become unpayable because the wages have not increased at the same rate as devaluation. This also generates problems in the finance market; therefore, the C.B bank injects once again money into the system, causing the problems to amplify. (Cordeiro)

In conclusion, in a flexible economy there could be more exports and a fall in imports. Nevertheless, the negative effects are greater than the positive effects, which are deterioration of the banks and an outflow of capital.

External shocks and dollarization

With dollarization, the negative consequences of an external shock are very similar and there must a way to adjust the budget.

However, the negative phenomenons with dollarization are not stronger than with devaluation. For instance, if a dollarized Ecuador experiences an oil or banana crisis, the people would not send their money out of the country, because there is not the risk of a possible increase in the exchange rate. Furthermore, the interest rates go up, showing a shortage of dollars, which makes it more attractive to keep the money in the country.

We also have to remember that the default risk could raise, which could lead to an outflow of capitals.

On the other hand, there is a serious issue with the salaries adjustment. In the devaluation system, there exists a big hypocrisy in the law: “the wages of the workers cannot be reduced”, but they will reduce via inflation or devaluation.

With dollarization, this situation will no longer hold true, because it is now impossible to devaluate the currency. Therefore, the law will now have to say: “ The employers and employees could renegotiate the salaries”. Most likely, not many people would accept this new law. Because of this reason, when the pie shrinks (external shock) and the salaries stay unaltered, the consequence will be unemployment.

Yet, what seems like hypocrisy has logic. What is easier? Coordinate thousands of salaries and prices between a great amount of economic agents, or devaluate the currency, which has a similar result.

Without a doubt, devaluation is easier and with a dollarized system, that would be lost. Unfortunately, unemployment is a more dangerous risk in a dollarized system, as opposed to a devaluation system.

In contrast, if there is no salary flexibility, then the economy has to find other mechanisms to adjust. The interest rates will have to increase to reduce consumption and investment. The regime will have to spend less resources and, at the same time, it would have to increase taxes.

Unquestionably, there will be pressure on the administration by social and political movements. But, if this method is not used, unemployment will be higher.

At this point, international financial integration becomes very important because inflow of capital could help Ecuador's stability. (Cordeiro)

Exchange Rate

Since the first announcement of dollarization, several arguments about the appropriate exchange rate have been exposed. Some analysts believed that 25.000 sucres per one dollar (actual exchange rate) was too low. Others held that 30.000 sucres per dollar or 40.000 sucres was an optimal exchange rate, which could have given Ecuador's economy a dynamic commerce. In contrast, some individuals manifested that the government exceeded the exchange rate; just 20.000 sucres per dollar could have been enough.

However, the reality is that determining the exchange rate is not a rocket science. The “price” of the exchange rate is the quantity of sucres in the economy divided by the quantity of dollars in the economy. Notice that the word “price” was used because the exchange rate is a price. For instance, lets pretend that an individual is willing to buy every Ford Taurus in his town with his total resources, 500.000 dollars--what is the maximum price he would be willing to pay for each automobile? Lets also assume that there are 50 Ford Taurus in his town. The calculation would be the money that he has, divided by the quantity of Ford Taurus in his town: 500.000/50= 10.000 dollars.

The quantity of sucres in the economy is determined by the following data:

Bills and coins in circulation + Banks' reserves in the Central Bank + Bonds of monetary stability + Government's reserves in sucres.

By the end of the first trimester of the year 2000, the quantity of sucres in the economy was 22 billions sucres. On the contrary, the quantity of dollars in the Central Bank's reserve was 950 million dollars. Therefore, the exchange should have been 23.000 sucres per dollar. (www.bce.fin.ec)

Additionally, the exchange rate was not fixed at 23.000 sucres, but at 25.000 sucres. The reason behind this fact is that the Central Bank wanted to keep some dollars in its reserves for possible economic misfortunes (70.000 million dollars).

Social consequences of the new price of dollar

The exchange rate has significant importance on the society; a higher price will indeed affect the Ecuadorians in a more drastic way than a lower price.

Ecuador used to be a semi-dollarized country; citizens used to be in debt in dollars, but their income was in sucres, which caused the debt payments to be extremely difficult. For instance, a person received 2500.000 sucres income and he or she had a 100 dollar debt; at that time, exchange rate was 5.000 sucres per dollars. This means that this person gave 25% of his or her income to debt payment. Now, with dollarization, this person will have to provide his or her entire income to the payment of the debt. Several companies were in similar circumstances.

Another sector of society that was affected by dollarization at the 25.000 dollars rate was the retire sector. The seniors received a retirement pension in sucres, which was reduced 5 times. These people faced another problem because they rely on the fact they could not increase their income. However, the government mandated, by law, price discrimination for these individuals.

The importers had a reduction in their profits because purchasing imported goods was 5 times more expensive for a citizen.

Finally, every price was transformed to dollars, but the wages did not increase, because of this reason, the general population had to reduce their budget 500% due to the equalization of prices.

Nevertheless, it is my opinion that the government could have avoided the social negative consequences by dollarizaing the country a couple of months before the reduction of the dollars reserves. Late decisions and lack of leadership could be terrible costs for the future. Additionally, the government should have searched for international dollars resources before officially dollarizing the country, which could have increased the dollars reserves, lowered the price of dollar and reduced the social consequences. It seemed that the government was more concerned with staying in the power than analyzing the dollarization.

Prices will not have an international level

Several predictions about dollarization have been made, including one that explains that Ecuador will have similar product prices as the U.S and the salaries will stay at the Ecuadorian level. The conclusions of this argument reveal that with dollarization, Ecuadorians will become poorer and unemployment will rise.

But this argument is not consistent with reality, for instance, in a dollarized country such as the U.S the prices vary between cities. The prices in San Francisco are not the same as Baton Rouge and the prices in Baton Rouge are not equal to New York. Furthermore, we can assume that the prices between countries are not the same; therefore, we can be positive that the prices in Ecuador will not be similar to the U.S. The reason beneath this truth is due to the following arguments:

First

Tradable items have different prices than none tradable items. Education, land and houses are not tradable between the U.S and Ecuador for obvious reasons. The prices of these items will depend on the demand and supply conditions of the domestic country. These conditions are general income, GDP, individual preferences, technology, laws, etc, which are exceedingly different between Ecuador and the U.S

On the other hand, items that are more tradable will tend to have a similar price such as sodas, automobiles, etc. But, once again, different demand and supply, transportation costs and import taxes will distort prices between nations.

Second

The highly labor goods have lower prices in places where the wages are low, such as restaurants or salons. If the producers have to pay lower wages to his or her employees, the production costs will be lower, making the price of the final product cheaper. In this sense, Ecuador and U.S have very different wages.

In contrast, highly capital goods have lower prices where capital is more accessible, such as communications, automobiles, etc. These goods in Ecuador will tend to equalize to international levels, otherwise the exporters will have a profit lost. However, this situation occurs with and without dollarization.

Third

In countries with higher income levels, the prices will tend to go up because people will be willing to pay more to purchase a certain item. In the U.S, the general minimal wage is between five and seven dollars an hour. On the other hand, the minimal wage in Ecuador is 0.75 dollars an hour. (Paredes)

International Competition

There is one truth about economy: countries can be competitive according to their resources and production advantages. In line with Ricardo's view: “…gainful trade is possible even if a nation has an absolute disadvantage in the production of commodities compared with other nations”(International economics).

According to this perspective, Ecuador will maintain its competitive advantage of cheap labor and natural resources. It could also improve the internal economic situation with the benefits that international trade provides.

However, this goal is possible with and without dollarization. The only aspect that Ecuador has lost is the power to devaluate its currency in order to pass the bump when it has a balance of payment deficit. But, we have seen that devaluation in Ecuador has brought more negative results than positive results.

Conclusion

Ecuador has gained the possibility of having exchange rate and inflation stability; it has also gained the power not to save banks and powerful groups via state resources. Similarly, it could gain a new style of economic policy, which avoids irresponsibility in government expenditure. In addition, Ecuador will have to improve its condition in difficult times by being more productive and entering new financial markets.

Conversely, Ecuador has lost the power to solve tribulations via a modification in the money supply. Moreover, Ecuadorians have vanished a part of their culture and a daily statement of their history.

On the other hand, the risk of unemployment in case of an external shock is looming, but this circumstance could occur with and without dollarization.

This topic is indeed polemic. However, a nation's wealth does not depend on miracle monetary policies. Rather, national prosperity is based on a country's productivity, laws and solid political structure.

Bibliography

Because dollarization was applied in Ecuador this project will use several Ecuadorian sources such as local newspapers, Ecuadorian Central Bank data and Ecuadorian economists' books to address this topic. These sources are to be found in Ecuadorian libraries, the Internet and Hatfield library.

• Banco Central del Ecuador (economic data). www.bce.fin.ec

• El Comercio (local newspaper). www.elcomercio.com

• Paredes, P. Lucio “El libro de la dolarización”. Second edition. Libri mundi. Quito-Ecuador 2000

• Cordeiro, Jose Luis. “La segunda muerte de Sucre”. First edition. IEEP. Quito-Ecuador1999

• Krugman, Paul. “Pop Internationalism”, MIT Press, Massachusetts (1997)

• Krugman, Paul. “The Accidental Theorist”, W.W. Norton & Company Inc., New York (1999)

• Friedman, Milton. “Monetary Mischief: Episodes in Monetary History”, Harcourt Brace, New York (1992)

• Carbaugh, Robert. “International economics”. South-Western.

• James Hanson. “International economics” .Lecture, Willamette University, Fall semester 2001.