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Ecuador and the Dollar

Nick Rosen

Ecuador, a poor, mountainous nation of 12 million on the Pacific coast of South America, arrived at dollarization on an economic roller coaster. The early 1990s brought the tiny economy a hopeful surge of growth fueled by oil, Ecuador’s principal export, as high crude prices and the construction of a new pipeline allowed for an impressive expansion in oil sales. The economy grew around 3 percent annually during 1993 and 1994, while annual inflation, once at sky-high rates, eased to 26 percent. Investors, excited by Ecuador’s oil bonanza, allowed Ecuador to borrow at will. But by the late 1990s, a glut of oil on world markets brought on the collapse of oil prices, the source of a major chunk of Ecuador’s revenues. Economic crises sweeping through Asia, Russia and neighboring Brazil further battered export markets and all but eliminated the ability for emerging countries like Ecuador to borrow money. Trade disputes between the United States and Europe, meanwhile, hurt Ecuador’s banana exports. And then there were the destructive forces of nature: first drought, followed by devastating rains brought on by the El Niño weather phenomenon, and then a disease-stricken shrimp harvest.

In the fallout from this turbulent chain of events, Ecuador’s economy contracted 7 percent in 1999, a downturn that worsened the plight of many already struggling to survive. Having borrowed heavily in the boom years, the government found itself laden with debt and it joined the ranks of the world’s financial outcasts by defaulting on $6 billion in loans. The bank system was also on a precipice. The government had frozen many bank deposits ten months earlier to prevent a bank run, and the looming deadline to "thaw" deposits precipitated expectations of a bank collapse. Ecuador’s currency, the sucre, bore the burden of this bad luck. Within one year, the sucre lost two-thirds of its value while inflation soared to 90 percent, levels reminiscent of the bleak days of hyperinflation in the 1970s and ‘80s.

Even though Ecuadorians had turned to the stability of the U.S. dollar well before the crisis to keep their savings or denominate their business contracts, President Jamil Mahuad rejected the idea of official dollarization as a "leap into the void." Adopting the dollar would mean relinquishing control over monetary policy, a key economic tool – printing money would no longer be a way to stimulate growth, finance public spending or bail out banks in crisis. Full-blown dollarization would also be nearly unprecedented, since only one other country, Panama, had done it before. Panama had adopted the dollar almost a century earlier, but it had many of the prerequisites economists deem necessary for successful dollarization, like a robust banking system and strong fiscal position. Ecuador could boast neither of these.

But as the clamor of business interests, indigenous groups and labor unions rose, Mahuad began to realize his political future was in jeopardy. So on January 9, 2000, he reversed his stance and made the "leap," calling for legislation that would legally replace the sucre with the U.S. dollar. Critics claimed the plan was merely an attempt to divide Mahuad’s opponents and shift scrutiny from his administration to the new, radical economic program.

To this end, his plan worked, at least temporarily. Polls at the time showed 60 percent of the Ecuadorian population, including many from the middle class, backed dollarization, and this support forced indigenous and labor groups to abandon their drive to depose the president. But Mahuad’s political respite would prove brief. Two weeks later anti-Mahuad protesters, backed by dissident military officers, stormed the presidential palace and ousted him. A ruling junta of military officers and opposition leaders was hastily established. After 24 hours the junta ceded power to Gustavo Noboa, Mahuad’s vice-president.

With civilian rule quickly restored and the opposition in disarray, President Noboa announced his resolve to continue with the dollarization plan. He argued that the move was Ecuador’s only hope to avert economic collapse: the dollar would arrest inflation, prevent devaluation and stabilize the economy, and investment and economic growth would surely follow. Additionally, the problems for macroeconomic policy posed by dollarization were seen by mainstream economists and financiers as a virtue -- the use of the U.S. dollar would require a much-needed restraint on profligate spending and inefficiency, which the Ecuadorian central bank could have otherwise masked by printing money.

Soon after, the International Monetary Fund headed up a consortium of public lenders that granted Ecuador a crucial $2 billion emergency loan package, funds that proved to be a turning point for the country. But not everyone at home was so pleased about the move to the dollar. The same labor and indigenous groups that had driven the former president from power were horrified by the surge in the cost of living and the erosion of their purchasing power that initially accompanied dollarization, which also prompted drastic cuts in social spending and price supports. Once again these groups marched angrily in the streets. Exporters from the non-oil sectors were equally alarmed -- how would they compete internationally if the government was unable to weaken the currency and make their products cheaper when global market conditions demanded it? Thanks to an eight-year boom in the United States, the U.S. dollar had been growing in value for years, meaning Ecuadorian goods would be unnaturally expensive to import. The robust U.S. economy also meant U.S. officials would be wary of inflation, so interest rates would stay high. Ecuador, on the other hand, was struggling with recession, a problem that is often addressed by monetary policy – lower interest rates. But because interest rates are directly linked to the supply of money, Ecuador would have little choice but to contract just when a stimulus was so badly needed.

With his political fortunes staked on dollarization and international lenders waiting expectantly, President Noboa shrugged off the resistance and in March 2000 the country fixed the exchange rate to 25,000 sucres, a daunting exchange rate for Ecuadorians still holding the old currency. The Central Bank was stripped of its principal function of handling monetary policy and left to oversee the banking system and mint coins of sub-dollar value. But first it was authorized to go on a massive dollar-buying spree, liquidating large portions of Ecuador’s foreign currency reserves and international investments. Bundles of greenbacks were flown in under heavy security. Sucres were bought back from the general public and dumped into paper shredders. As this was happening, the streets of Ecuador exploded with activity as people struggled to adjust to new life under the dollar. A cottage industry of black market currency exchanges sprung up and money vendors suddenly appeared everywhere while the population attempted to figure out the once-simple task of making change.

Ecuador’s first year under dollarization brought ups and downs. Investment went up, although this was the result of a number of factors besides just dollarization, including higher oil prices and an improved fiscal position. Capital flight eventually subsided and reversed, as roughly $600 million in private savings returned to the banking system. But inflation persisted, rising to 91 percent in 2000. A poll that year showed 69 percent of the population now opposed dollarization as respondents complained they were earning less and their buying power had shrunk.

Still, Noboa stayed the dollar course, and today, many indicators seem to vindicate his decision. The economy expanded 5.5 percent in 2001 -- the fastest rate in Latin America -- on the back of rising consumer spending and investment. Interest rates are down and inflation appears more or less under control, hovering around 13 percent annually. Yet looking forward, the program’s ultimate success remains an open question. Much of the renewed confidence and economic growth in Ecuador can be attributed to dollarized stabilization, but not all of it. Rising oil prices, as always, have been a decisive factor. Some argue that these kinds of external factors, not monetary regimes, still govern Ecuador’s fate.

The country now finds itself extremely vulnerable to market shifts, since it can no longer devalue its currency to respond to outside shocks. A fall in the price of oil or other key export commodity, for instance, would hit the country with unmitigated force. Any sudden economic blow would undoubtedly threaten the already weak banks, which, without the privilege of bailouts from Ecuador’s now-impotent central bank, could face extinction. There is also great concern that without the liquidity and the support of the Central Bank, domestic banks will be unable to extend the credit necessary for growth and job creation.

Lacking monetary policy, one of Ecuador’s only means of staying competitive is through micro-economic reforms that can increase the economy’s efficiency and allow it to adjust with greater flexibility to external shocks. And many of the key reforms meant to accompany dollarization, such as price hikes for public services and cuts in subsidies, have yet to be enacted and still face daunting public opposition. Any austerity measures introduced in Ecuador’s fragile political climate could very well spark a return to riots.

Indeed, the population remains restive, as many of Ecuador’s perennial problems show little sign of disappearing. More than 70 percent of Ecuadorians still live below the poverty line and dollarization has been slow to benefit lower income groups because wages have yet to catch up with prices. The state, too, struggles to keep its head above water as Ecuador remains the largest per-capita debtor in Latin America.

In the wake of the recent crisis in nearby Argentina, where a one-to one-peg to the U.S. dollar ultimately crippled the growth prospects of a debt-laden economy and helped cause full-blown economic and political turmoil, many Ecuadorians still wonder whether the dollar will bring long-term growth and prosperity, or merely a brief rest on an increasingly uncertain and precarious road.

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