DEPARTMENT OF ECONOMICS WORKING PAPER SERIES
Is It Possible to De-dollarize? The Case of Ecuador
Kenneth P. Jameson
Working Paper No: 2003-07 November 2003
University of Utah Department of Economics 1645 East Central Campus Dr., Rm 308 Salt Lake City, UT 84112-9300 Phone: (801) 581-7481 Fax: (801) 585-5649 http://www.economics.utah.edu
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Is It Possible to De-dollarize? The Case of Ecuador Kenneth P. Jameson Department of Economics, University of Utah
[email protected]
ABSTRACT The policy reform termed dollarization, adoption of a foreign currency as the domestic currency, is widely believed to be irreversible. The paper presents counter examples, while noting that the Latin American “hard pegs” present problems that are more complex. It then uses Ecuador, the longest-lasting of the recent dollarizers, to examine all aspects of the possibility and process of de-dollarizing. Presentation of economic performance before and after dollarization leads to consideration of possible steps that could maintain the policy. Examination of the benefits of dedollarization follows, with careful consideration of how a process of de-dollarization might be implemented. Since Ecuador may embark on this course, the paper provides a comprehensive and necessary examination of the issues involved Keywords: Dollarization, Ecuador, de-dollarization, Dollar bloc, exchange rate regime, seigniorage JEL Classification: O1, O5.
2 INTRODUCTION The conventional wisdom among analysts is that official dollarization is asymmetrical. Once a country adopts the dollar as its domestic currency, it is impossible to reverse course and restore the national money. In other words, “dollarization,” or the adoption of any foreign currency as the national money, is widely viewed as an end game. For example, “in a dollarized economy, reintroducing the national currency would be virtually impossible. Authorities would have to convince residents to turn over their dollars and convert dollars back into the national currency” (Magaña 2001). Reporting on business interest in dollarizing Honduras, Noticen (2002, 2) concluded “The country would be saddled with monetary policy set for and by the US, a vulnerability that would overhang national security forever. Dollarization is irreversible.” Even unofficial and partial dollarization is widely viewed as asymmetrical. Feige et al. (2003) suggest that the network externalities that exist beyond a threshold of 35 percent dollarization make the process irreversible. At that point, the transaction cost of using dollars becomes less than the cost of switching back. Similarly, Dean (2001, 295) states that “(i)nformal use of US cash—currency substitution—has now become so widespread in Latin America that it may be irreversible due to exponentially growing network externalities.” High inflation rates are often the reason for adopting a nominal anchor such as the dollar. But again, observers claim that “(a)n asymmetric relationship apparently exists between dollarization as the domestic inflation rate rises and de-dollarization as the inflation rate falls” (Melvin and Peiers 1996, 38). Network externalities are often invoked in this case as well. “Switching currencies involves substantial fixed transaction costs stemming from network economies within the payments system. These switching costs prevent a rapid de-dollarization when inflation falls” (Humpage 2002, 3).
3 Nonetheless, history offers many cases where national monies successfully replaced an externally issued money. One prominent example was the United States, whose most stable medium of exchange through much of the 19th century was the Mexican dollar. The U.S. government had to go to great lengths to establish its own dollar and to create conditions that guaranteed its acceptance internationally (Piatt 1904). In most cases after World War II, a domestic money was established in response to increased political autonomy and a consequent desire to attain greater economic independence. Decolonization in Britain’s African and Caribbean colonies took place when the sterling bloc was weakening, which provided a double justification for creating domestic monies. In France’s African colonies, greater financial stability and a different decolonization process resulted in creating two monetary unions with France, the CFA Zone. They have endured until today, though the mechanisms have been relaxed to allow greater domestic latitude for the CFA countries. The most recent large-scale decolonization process, the dissolution of the USSR, also led to establishing national currencies in most of the former Soviet Republics, though several dollarized.1 Thus the answer is certainly “yes, it is possible to create a domestic money to replace a foreign money,” despite the common opinion to the contrary. Nonetheless, the difference in starting points raises many questions about the feasibility of de-dollarization in already politically independent countries such as Ecuador, El Salvador, or Panama. The historical examples indicate that such a policy change is unlikely to result from careful, dispassioned economic analysis and policy evolution. Rather, crises and path dependence are more likely to dominate any such decision (Alston and Gallo 2002; Jameson 2003). On the other hand, a clear
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Another recent decolonization, East Timor’s secession from Indonesia, also resulted in the adoption of the dollar. This indicates that the transition authorities recognized the stringent limits on monetary independence and also accepted the centrality of the dollar, the world’s “great money” (Mundell, 1998).
4 understanding of the baseline conditions, of the de-dollarization process, and of its implications could improve the results of de-dollarization, irregardless its genesis. This paper concentrates on Ecuador, which has the longest experience among the newly dollarizing countries. After briefly describing the genesis of the recent Latin American “hard pegs,” including dollarization, I examine the benefits and costs to Ecuador. Since policy flexibility diminishes with dollarization, the next section asks where policy space could be gained in the effort to preserve that monetary regime. This option is next measured against the gains from de-dollarizing the country. It is clear that there would be substantial costs to such a policy reform, determined largely by how the process was undertaken. The final section considers possible scenarios for de-dollarization in Ecuador. The crisis in Argentina ended its hard peg, convertibility. Economic problems in Ecuador could similarly end dollarization; the costs in that case would be extremely high. The implication of my analysis is that those costs could be reduced by a conscious process of policy “reform,” designed to take advantage of the benefits of more flexible exchange rates and to minimize the expectational and network externality costs of de-dollarization.
LATIN AMERICA’S HARD PEGS AT CENTURY’S END Today’s circumstances in Latin America are quite different from countries gaining political independence from a colonial power, although any decision about dollarization has definite implications for economic policy independence. The “hard pegs” such as Ecuador’s dollarization, Argentina’s convertibility, and the real plan in Brazil were adopted in response to persistent economic instability in the 1980’s and 1990’s. They implied that an independent monetary policy was no longer available to those governments. The hard pegs became one of the
5 poles of the widely accepted “bi-polar” view of exchange rate regime, designed to avoid exchange rate collapses (Fischer, 2001). The other pole was the floating exchange regime. Argentina’s convertibility was a response to economic stagnation, accompanied by hyperinflation, and was implemented by a government whose economic policies had initially failed. Macro instability had adversely affected the efficiency of markets, so limiting monetary emission quickly restored relative price stability and facilitated domestic economic decisionmaking. Brazil’s real plan had similar antecedents and built on an initial effort to use the exchange rate as a nominal anchor. This hard peg allowed macro stability from 1994 until the external shocks from the Asian and Russian crises of 1997-98. In Ecuador, domestic and international policy incoherence in the 1990s reflected a perennial political impasse, which finally interrupted international capital flows in 1999. The result was an exchange rate crisis that was solved by the adoption of the dollar as the domestic currency in 2000 (Jameson, 2003). The later official, though partial, dollarizations in El Salvador and Guatemala were the result of a different historical process. Civil war and U.S. involvement generated a long period of citizen emigration to the United States. As a result, both countries have become “split nations,” existing both in their original geographic area and as a sub-national presence within the United States (de la Campa, 1999). These partial dollarizations, which El Salvador initiated by forcing conversion of financial transactions to dollars and Guatemala by allowing transactions to be undertaken in any currency, provide a common monetary unit for both geographic components of these nations. This policy reform occurred after a long period of relative exchange rate stability in both countries, and was not a response to crisis. Efficiency gains in transactions are likely, in the spirit of optimal currency area theory; however, the effect of the adoption of the dollar on the identity of the new “nation” may be even more important.
6 The exchange rate regime occupied center stage in the 1990s in Latin America, which exhibited a notable “fear of floating” (Calvo and Reinhart, 2000). The hard pegs became attractive because they provided nominal stability: inflation fell and exchange rate crises became less frequent, though they did not disappear. Their real effects were more ambiguous, however. Argentina suffered a four-year recession before policy-makers decided that the country had to abandon the hard peg. In the midst of an economic and political crisis in early 2002, they ended the convertibility mechanism, but at great cost—12 percent decrease in per capita GDP in 2002. In 1999, Brazil abandoned the real plan and floated, when it could no longer maintain stability in the face of contagion from the East Asian and Russian crises. The effects were less catastrophic, though growth fell almost to zero in 2001 and 2002. While these hard pegs were replaced by more flexible, though managed rates, dollarization has continued in Ecuador, and of course in Panama.2 El Salvador and Guatemala expect dollarization to grow. However, their economic growth has remained sluggish and performance indicators are modest at best. This suggests that they may revisit dollarization in coming years. In Ecuador, economic performance greatly improved after dollarizing in 2000. However, the instability of economic policymaking and growing political and economic tensions mean that the continuation of dollarization remains in question. For example, the powerful Mayor of Guayaquil and former presidential candidate, Jaime Nebot, recently stated that “dollarization is in serous danger because supply has faltered, competitiveness has been eroded, and there is excess government spending and poor handling of the public debt” (El Universo 2003). So whether and how Ecuador might exit dollarization is a pressing issue that must be part of the policy debate. To that we now turn. 2
Though there is business interest in dollarizing Honduras and President Fox surprised the other NAFTA members by suggesting it be considered in the June 2003 consultation (Carlsen 2003), hard pegs seem much less attractive after Brazil and Argentina abandoned them.
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THE BALANCE SHEET ON ECUADOR’S DOLLARIZATION There is general consensus about dollarization’s effects on Ecuador’s economic performance since 2000, as well as on the growing imbalances and economics pressures. Observers across the spectrum from Kurt Schuler (2002), a resolute supporter of dollarization, to Alberto Acosta (2002), an early and continuing critic of the program, agree that dollarization was successful between 2000 and 2002. However, analysts differ on how much of the performance to attribute to dollarization and how much to favorable external conditions and the natural rebound from the profound economic instability of 1999. In that year real GDP decreased by 6.3 percent. Most importantly, analysts differ on the sustainability of dollarization. The dollarization decision was influenced by, or path dependent on, a spirited dollarization debate (Jameson 2003). Any policy changes will also be influenced by this on-going discussion, whose vitality suggests the possibility of policy reversal, particularly if economic performance deteriorates. Table 1 provides data on macroeconomic performance in Ecuador from 1997, the first year of the political crisis, through 2002, the third year of dollarization. There are many positive indicators. Real GDP grew by 5.1 percent in 2001 and 3.4 percent in 2002. This was 3.3 percent and 1.6 percent in per capita terms, the highest Latin American growth rate. Inflation averaged 35 percent from 1980-1998, but accelerated to 52 percent in 1999 and 96.1 percent in 2000. It then fell to 37.7 percent in 2001 and 12.5 percent in 2002. The reduced inflation is good news, though it is tempered by the accumulated inflation; and inflation remains above international rates.3 In 2003, inflation continued to decrease, with declining prices in some months.
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Schuler (2002) calculates a rate of inflation “in dollar terms” that closely follows international rates, since inflation rates in 1999 were only half the rate of depreciation of the sucre. By his calculation, the very high 2000 rate was simply a catch-up to international prices and thus does not imply an overvalued real exchange rate.
8 Dollarization affected inflation through the growth of the monetary base, whose 174 percent increase in 1999 fell to 15.7 percent in 2001 and 5.2 percent in 2002. Fiscal policy, under pressure from the IMF, was also deflationary. The deficit of 4.8 percent of GDP in 1998 became a continuing surplus after 2000. The primary surplus reached 4.7 percent in 2000 and was 4.2 percent in 2002 after dropping to 0.8 percent in 2001 as a result of higher salaries and lower oil revenue. Unemployment has declined from 15.1 percent in 1999 to 10.4 percent and then 8.7 percent in 2002. This is partly the result of continued emigration, though the labor market has clearly improved. The real wage index has risen, despite a fall in 2002. However, it remains far below its 1997 value. Gross fixed investment increased from 16.9 percent of GDP in 1999 to 22.8 percent in 2002. This was partly the result of increased foreign direct investment, which doubled from $648 million in 1999 to $1,330 million in 2001, before declining to $1,275 million in 2002. The increased investment reflects another favorable result of dollarization: increased access to international capital flows. The capital and financial account outflow of $1.3 billion in 1999 and $6.6 billion in 2000 became an inflow of $918 million in 2001 and $1 billion in 2002. Much of this was for construction of the heavy crude oil pipeline, though diminished capital flight was also a factor. Capital inflows financed current account deficits of $550 million in 2001 and $1.2 billion in 2002. These deficits would have been far higher without positive net transfers of emigrant remittances, which rose from $1.1 billion in 1999 to $1.4 billion in 2002. Closer examination of these indicators shows why opinions differ on whether positive economic performance will continue. In actuality, even the proponents of dollarization believe that further changes must be made, implying that they share concerns about dollarization’s
9 viability.4 Critics note a number of continuing problems and believe that they will become more acute over time. Interest rates remain high, over 15 percent, and the loan-deposit spread actually increased after 2000. This discourages domestic investment. In addition, country risk remains high, as measured by the sovereign debt spread, indicating that the capital inflows for the oil pipeline misrepresent the appeal of Ecuador to foreign capital owners. The spread fell from its high of 2,754 basis points in 1999 to 1,186 in 2001, but rose again to 1,794 at the end of 2002, as Lucio Gutierrez became president. By July 2003, the spread had retreated to 1,209 basis points as the new administration tried to calm financial markets (Dresdner Bank Lateinamerika 2003). Nonetheless, in Latin America only Argentina faces a greater spread; even chaotic Venezuela is treated as less risky. The spread primarily reflects country risk; however, its magnitude suggests that the probability of de-dollarization is estimated to be far greater than zero. One reason is that a capital flow reversal upon completion of the pipeline will exert a deflationary influence, exacerbated by the already weak current account. The real exchange rate of Ecuador has become extremely overvalued since 1999, even in comparison with its pre-crisis value. ECLAC (2003, A-8) calculations show that it is far more overvalued than any other Latin American country. The chaos of 1999-2000 may distort this in some degree. However, exports have stagnated since 2000, despite improvement in the terms of trade as a result of oil price increases. The number of registered exporters fell from 2500 to 1400 in the first half of 2002 (ILDIS, 23). At the same time, imports surged.5
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In several discussions on dollarization during 2002 in Ecuador, the only exception among proponents of dollarization was at the Quito Chamber of Commerce. The members present dismissed any suggestions that problems with dollarization might require further policy changes. 5 GDP fell by .5 percent in the first six months of 2003, while unemployment rose and investment feel. Inflation slowed further, but this performance and the likelihood of only slightly better results in the rest of 2003 and in 2004 reinforce the dollarization skeptics.
10 The interpretation of these indicators is the focus of the debate on dollarization’s continued viability. Some point out that non-traditional exports have grown slightly and that the growing current account deficits are a sign of the viability of the status quo. The more common view is that increasing pressures of the overvalued exchange rate on the now dollarized economy are masked by emigrant remittances and capital inflows for the oil pipeline. Without changes in economic policy, or increased access to international capital flows, the economy will slow and enter a prolonged recession similar to Argentina from 1998-2002. The critics maintain that dollarization will have to be abandoned (Acosta, 2002). On the other hand, Schuler (2002) minimizes the importance of the international imbalances. By implicitly assuming a pass through coefficient of one, he asserts that depreciation of other countries’ currencies will not affect Ecuador’s competitiveness, since the other countries’ rates of inflation will increase in step. In addition, though the share of consumption imports rose from 19 to 27 percent, the result of a “restocking boom” in durables, capital goods’ share also rose from 24 to 33 percent, suggesting that investment may stimulate the domestic growth and increased productivity necessary to maintain the model.6 In addition, the depreciation of the dollar against the Euro will aid Ecuador’s competitiveness. Yet even Schuler has concerns about the continued viability of dollarization, for he suggests a series of reforms, mainly in the fiscal and monetary area: tax simplification, reduction of the value added tax, reforms to the budgeting process, increased budget information, and improved scrutiny of government companies. In other words, he looks to the fiscal accounts to provide the margin needed to maintain the program. The fiscal accounts had already moved from a deficit of 4.8 percent of GDP in 1999 to surpluses after 2000. This was in part due to increased 6
A cautionary note comes from the experience of Argentina where productivity, output per worker, increased by 46 percent between 1991 and 1998. This was not sufficient to avoid recession and final economic crisis (Fanelli and Keifman, 2002).
11 revenue from improved economic performance and better tax collections. It also reflected the reduction in “social investment expenditures” that now account for only 15 percent of government expenditures, compared with debt service’s fifty percent (ILDIS, 2002). Indeed, one of the sticking points in recently concluded negotiations with the IMF had been the IMF insistence that seventy percent of the revenues from the new heavy crude pipeline be committed to debt buybacks (MEF, 2003). The IMF also strongly opposed more than token revenues for social expenditures, requiring that only 10 percent of the new revenue go for social expenditures. Most agree that increased emigrant remittances, higher oil revenues, and support from international financial institutions allowed better than expected economic performance after Ecuador dollarized in September 2000. Will these favorable factors continue? The data suggest that remittances have leveled off and may be declining (ECLAC, 2003 A-11). Oil prices continue high and so may continue to provide support. The IMF has become increasingly demanding and protective of international creditors. Thus, those resources may be less available to maintain economic performance, despite the recent agreement on a $240 million loan and its trigger to $300 million of loans from other IFI’s. In addition, net external resource transfers to all of Latin America have deteriorated from a negative $169 million in 2000 to a negative $39 billion in 2002, with only Mexico seeing significant positive transfers (ECLAC 2003, A-17). Thus, the likelihood of such a reversal in Ecuador’s capital account is high. It is unlikely that further fiscal adjustments could provide the policy space necessary to maintain dollarization, in the face of deterioration in the external accounts. Unless there are significant changes domestically, the most likely scenario is gradual stagnation and deepening economic crisis, along the lines of Argentina. As Calcagno, Manuelito and Titleman (2001, 39) put it: “In Ecuador, dollarization began with propitious external and fiscal conditions, but a less
12 favorable conjuncture would pose the same challenges that Argentina had to face.” How Ecuador could gain policy space to confront an economic crisis, while maintaining dollarization, is an important question. We examine it in the next section. HOW COULD ECUADOR MAINTAIN DOLLARIZATION? In early 2003, the new Gutierrez administration scrambled to raise energy prices so that a long-delayed IMF loan would be approved. The war in Iraq increased the price of oil exports, which provided a fiscal cushion. The recent weakness of the dollar should aid export competitiveness. However, evidence suggests that these favorable elements will likely diminish, and continued stagnation in the U.S. will only accelerate this process. Thus, in order to stave off economic crisis and to avoid a chaotic de-dollarization, new approaches to economic policy must be found that can provide a firmer basis for the economy. When the Gutierrez government took office, there were several possible areas where economic and political space could be found: Domestic social pact Continued internal political incoherence and disagreement on economic policy weakens the ability of any government to confront these increasingly difficult times. Gutierrez partially incorporated elements of the indigenous movements in his Sociedad Patriótica electoral coalition. However, his low coastal support was problematic. The overvalued exchange rate could generate support from some sectors of the coast hurt by dollarization for a broader range of policies. Gutierrez’s coalition proved very unstable and his policies led to the indigenous movement’s withdrawal. His closest allies have been from his original opposition. He may be able to forge new alliances, though the instability of Ecuadorian politics makes that doubtful. It appears that he will govern with a narrowing base of support. The ability and willingness of the
13 indigenous movement to destabilize the government will move to center stage, mirroring the experience of Bolivia in the fall of 2003. It has become clear that the possibility of a social pact has rapidly diminished. Stabilization Funds The increased oil revenues or the increased tax revenues from better enforcement could allow the government to establish stabilization funds that could be used to offset cyclical behavior. If economic conditions continue to deteriorate, such “rainy day funds” could buy space before radical policy changes were undertaken. Another Argentina might be avoided. The IMF supports one aspect of this policy, using increased oil revenues to retire debt. While the new oil pipeline provided hope for such an effort, the deterioration of the fiscal accounts at the end of the Noboa administration made it quite difficult. Moreover, the apparent inability to fill the new pipeline suggests that the fiscal effect of that investment may actually be negative. Added international capital flows Argentina was able to maintain convertibility for several years through its access to international organizations and international saving. Gutierrez has already gone to this well, and the agreement with the IMF is likely to provide an inflow of up to $500 million. Ecuador’s support of U.S. policy in Colombia may aid access to U.S. public resources. However, Ecuador will have difficulty attracting private international capital. The current concentration of capital flows in China will affect Ecuador’s access, as will its high economic and political risk ratings. Of 94 countries rated in May, 2003, Ecuador ranked 78th in short-term political risk and 77th in short-term economic risk (Latin American Monitor 2003).
14 Diversification of export markets The continuing depreciation of the dollar will increase the competitiveness of Ecuadorian exports to non-dollar countries. However, in 2000-2002, only 30 percent of Ecuador’s exports were outside of the Western Hemisphere (ILDIS 2002). A concerted effort to develop markets in non-dollarized areas could provide some dynamism for the export sector and offset the overvaluation relative to other Latin American countries. Cultivation of diaspora Ecuadorians In contrast to Mexico and the Fox administration’s concerted efforts to link diaspora Mexicans with their nation of origin, Ecuador has no similar program. Policy initiatives in this area could have two benefits. First, it could encourage continuation of resource transfers to Ecuador, which will have a tendency to diminish over time as identification with the country of origin attenuates. Second, the magnitude of the emigration in recent years is staggering, at least one million since 1998 out of a total population of 12 million. The emigrants have gone to Europe and North America where their numbers appear small. However, as a group combined with other Latino immigrants they have the potential to influence the political process in their new homes in favor of their country of origin. While this would be a long run process, it could potentially provide important support for Ecuador in two areas. The first is the foreign debt and the terms of a renegotiation in favor of Ecuador and other struggling countries. A second role is to support of tangible recognition of Ecuador’s “loan” to the U.S. through dollarization. The long-run goal would be agreement to share some portion of the U.S. seigniorage and access to lender of last resort support from the U.S. Humpage (2002) and Guidotti and Powell (2001) provide specific proposals in this regard.
15 Regional focus Currently, the international financial institutions are less supportive and more demanding of Latin American countries in an attempt to protect themselves from other Argentina’s. In addition, regionalism appears to be on the rise. Presidents Lula and Chavez are more attuned to the needs of Ecuador than their predecessors and more willing to encourage regional cooperation. This could translate into increased access to regional resources for Ecuador. More importantly, it could provide support for efforts to change the international constraints the country faces, e.g. making the IMF more open to reaching new loan terms more favorable to Ecuador. There has also been consultation and research on implementing regional currencies, for example in the Mercosur (Fanelli and Heymann 2002). The Andean group has considered a regional currency that might give Ecuador added space (Jaramillo 2001). When Nina Pacari was Foreign Minister of Ecuador, she indicated she would encourage more active work on this possibility (Carlsen 2003). These steps could be taken to postpone a major crisis in Ecuador, though they are likely to be long-term solutions with less effect in the short- to medium-run. For a variety of reasons, they may not succeed in changing the nature of Ecuador’s economic situation. Therefore, Ecuador may have to consider de-dollarizing at some point not far into the future. Again quoting Calcagno, Manuelito and Titleman (2001, 39): “But it is not evident, at least in (Argentina and Ecuador)…that it will be desirable, or even possible, to keep such regimes in the long run. The lack of international competitiveness and the over-indebtedness may lead to a default risk, which brings the exchange risk back into the scene. As a consequence, the issue of how to exit from a hard peg regime is open.” They were correct about Argentina, and their prediction for Ecuador is plausible. So let us now turn to examine de-dollarization as an alternative.
16 WHAT COULD BE GAINED BY DE-DOLLARIZING? The orthodox free competition model dichotomizes the real sector and the monetary sector; the exchange rate regime is a peripheral concern. In the long run, the monetary sector and exchange rates only affect the price level and the mix of output between tradable and nontradable goods. Resources will move to their most efficient use and full employment will be maintained at its natural rate. Thus, Allan Meltzer (2002) wrote against the $30 billion IMF loan for exchange rate stabilization in Brazil by arguing, “economics teaches that money can solve monetary problems, not real problems. Populist and nationalist policies are real shocks. The IMF should stay away because money cannot solve Brazil’s political problem.” It is true that “populist and nationalist” concerns have meant that de-dollarization has never been completely off the policy table in Ecuador. The loss of a national symbol was not taken easily. The popular poster of General Sucre, whose name adorned the domestic currency, with a bullet wound in his forehead and the caption “Hasta la Vista, Baby!” captured that sense of loss. The disappearance of monetary policy independence has also remained a point of conflict, despite former Vice-president Dahik’s triumphant declaration on dollarization: “Society needs to understand that this is not a change in the monetary and exchange rate system. It is a reconquest and renewal of Ecuadorian society...It is a new order insisting on privatization and elimination of the privileges of bureaucratic sectors” (Pallares 2000).7 De-dollarization would directly address these losses. More importantly, there is ample evidence that the exchange rate regime can have significant real effects (Studart 2001). In addition, the balance between real and monetary effects of exchange rate changes may have shifted toward the real in recent years. Specifically, the link 7
Helleiner (2003) provides a detailed and intriguing exploration of the role of these factors in the widespread creation of national monies in the 19th century.
17 between exchange rate depreciations and increased domestic inflation, the “pass-through,” had diminished by the end of the 1990s. For most of the decade, devaluation would immediately increase inflation, i.e. the pass-through coefficient was close to one. However, the recent maxidevaluations of Argentina and Brazil have had a much lower inflationary impact. Argentina’s chaotic 70 percent devaluation only generated a 41 percent inflation rate in 2002, and Brazil’s maxi-devaluation only resulted in inflation creeping into the double digits. One year later, Argentina has begun to experience deflation and in 2003 both currencies appreciated. This may reflect increased credibility of Central Banks and increased sophistication of policy makers. It also signals changes in inflationary expectation formation, after nearly a decade of relatively modest inflation. This provides policy makers greater latitude, i.e. using the exchange rate to aid international competitiveness may be more effective than it had been in earlier years. Thus the ability to depreciate, after an economy is de-dollarized, may have significant competitive benefits. There are three specific areas where de-dollarization could improve economic performance in Ecuador. Improved micro-macro linkages Fanelli and Medhora (2002) found that changes at the macro level can disrupt firms’ operations and lead to important micro level real effects. The external constraint is important because of two characteristics of Latin American economies: lack of trade diversification is compounded by imperfections in international capital markets. In addition, developing country factor markets have greater imperfections, which affect competitiveness and growth. As a result, the issue of competitiveness cannot simply be reduced to pricing behavior; there are many dynamic factors that must be included. A variety of micro/macro links can have important real
18 effects. For example, financial flows can increase the rate of investment, choice of an exchange rate regime may affect the adjustment path, and both will affect competitiveness. As an illustration, I interviewed an executive in Quito in mid-2002 whose firm produced a number of popular consumer products. He described to me how, after dollarization, he had been systematically forced to reduce the domestic content of his products because of the noncompetitive prices of domestic inputs and increasing international competition. In addition, he had to restructure his financing to account for this new reality. De-dollarization could improve these micro/macro linkages and aid the efficiency of domestic production. Increased macroeconomic stability and policy independence At this point Ecuador has very little policy autonomy. Its monetary policy is essentially established in Washington and its fiscal policy is constrained by the conditionalities imposed by international organizations. Reestablishment of domestic economic policy autonomy would provide Ecuador added degrees of policy freedom, so that it could undertake policy steps to deal directly with external and internal shocks. Of course, one of the main reasons for dollarizing was to tie policy-makers’ hands. The stability of a U.S. economy, which was in the midst of its longest expansion on record, was an added attraction. Since that time, the U.S. has suffered one recession, and 2003 saw only modest improvement. Perhaps the most favorable aspect of Ecuador’s link to the U.S. is the recent depreciation of the dollar against the Euro. However, the U.S. is Ecuador’s main trading partner, accounting for 36 percent of exports between 2000 and 2002; as a result, the benefits of U.S. dollar depreciation will be moderate (ILDIS, 2002). The same is true of China, whose exports to Ecuador have risen rapidly but who has maintained a rate fixed to the dollar.
19 That leaves the question whether greater independence for domestic policymakers would lead to increased domestic economic stability. This is very difficult to answer; it suggests that dollarization was in many ways too easy. It did not resolve the underlying economic contradictions, particularly on the fiscal side, and may simply have transferred them to other arenas. It is possible that de-dollarization could force fundamental agreement on economic policy and direction, predicated upon reaching the compromises necessary to maintain economic stability. Increased access to foreign saving Access to foreign saving continues to be an important determinant of growth in virtually all Latin American countries. In Ecuador, the positive effect of dollarization was rapid and significant, both for increased private and public inflows and for rescheduling $3.5 billion in existing debt obligations. The public sector in Ecuador currently has little access to capital markets, and the public debt has remained relatively stable since January 2001 at $11.2 billion. On the other hand, private external debt has grown, more than doubling from $2.2 billion in 2001 to $5.1 billion in April 2003 (BCE 2003). As expected from Ecuador’s debt rating, much of this debt appears to be short-term, since the monthly flows are quite unstable (ILDIS, 2002). Could de-dollarization improve the capital account, especially since it is likely to occur during a time of crisis? Although this seems unlikely, if de-dollarization was used as a mechanism for increasing exports and as part of a package of reductions in the debt burden, in an effort to avoid another Argentine default, it might attract added foreign capital inflows. Increased export potential might also encourage added foreign investment, again aiding the capital account. This would only be possible if the stability of the resulting exchange rate regime convinced international
20 capital markets of its viability. In this regard, that Argentina’s capital inflows increased significantly in 2003 provides support for the plausibility of this scenario. Thus, to the extent that a de-dollarized economy could perform better in these three areas, there is a rationale for changing the exchange rate regime. Although reestablishing a domestic currency would not in itself solve Ecuador’s economic problems, a number of benefits could accrue. Of course, any long run solution would have to address the underlying economic problems noted above. In any case, the analysis suggests that the de-dollarization alternative should be kept alive as a possibility. This raises the final question: how might Ecuador dedollarize? HOW COULD ECUADOR DE-DOLLARIZE? International pressures and their interaction with domestic incoherence led Ecuador to dollarize; the same would be true in any effort to reverse course. The El Niño shocks and political instability led Ecuador to ignore policy constraints, which ultimately caused the crisis that forced dollarization. However, that path had been established through years of discussion and policy advocacy (Jameson 2003). There is evidence that these contraints will face a number of challenges in coming years that could allow countries greater flexibility in their international policy. The Argentine default remains to be played out completely under the Kirchner government. It may signal a willingness of Latin American countries to press debt holders for better terms and more responsiveness. Argentina’s flight from convertibility may have also paved the way for calm consideration of possible movement away from a hard peg. The willingness of the Chavez regime to disrupt existing power relationships, despite its domestic economic costs, may encourage other countries to seek consensus among competing interests, a requirement for any effort to de-dollarize. Finally, Lula’s presidency in Brazil signals that
21 nationalist efforts are likely to find support from this most important Latin American country, as was the case in the failure of the Cancun WTO ministerial meeting. A closer look at Argentina provides a cautionary note. Although Argentina had not dollarized, the end of convertibility has many lessons for any country that wants to break a hard peg, such as dollarization. The first lesson is that the link to political stability is asymmetrical. If there is no political coherence, a country can dollarize, as in the case of Ecuador. This may provide political space, since dollarization limits government discretion and narrows the focus of the political battle. On the other hand, if there is political strife and incoherence, abandoning a hard peg will simply intensify the political strife. The depreciating exchange rate reinforces instability, while changing asset values redistributes income and antagonizes large segments of the population. Second, the soap opera played out by Argentina and the IMF shows that only strong international backing for the policy change can counter short run speculative attacks on the currency. If tangible IMF support is not offered, the only bottom for the currency is a value that stimulates exports and reduces imports so that trade generates dollar surpluses. The capital account will be a continual drain. The final lesson is that the longer a country waits to deal with the disparity between productivity growth and domestic cost increases, and consequent exchange rate overvaluation, the harder to escape a hard peg. Therefore, the argument in favor of de-dollarizing must be made early, and the supporting coalition must be established with international approval long before the economy deteriorates. The Argentine recession after 1998 contributed to the depth of the crisis of 2001. Let us now turn to de-dollarization specifically, and how it might be accomplished, always assuming that domestic and international interests come to align in favor of the policy
22 step. A de-dollarization process should start with public acknowledgment of the costs to Ecuador of being dollarized. The clearest cost is the loss of seigniorage, all of which accrues to the U.S. The public must be made aware of the cost to the country and the benefits to the U.S. The desirability of policy independence would be the second point to be made. In this case, Chile could be taken as an example and its economic policy explained and used as an example of how Ecuador could benefit from a change in the exchange rate regime. Gains from network externalities should also be acknowledged, though there should be a residual ability to operate in two currencies or a domestic currency that should last for a number of years. Next, there should be an effort to change the rules and to renegotiate the conditions of dollarization. In this case, the basis that had been laid in Argentina would be quite helpful. Pres. Menem advocated dollarizing Argentina in 1998. Even before his proposal, economists in Argentina’s Treasury had drafted a dollarization proposal and had discussed it with U.S. policymakers (Guidotti and Powell, 2001). It was quite innovative and proposed a mechanism for sharing seigniorage, based on interest that would be earned on the reserves that would be converted into dollars. In addition, they proposed financial instruments that could provide the resources for a “lender of last resort” financing under extreme conditions. Discussions in the U.S. Treasury did not lead to a rejection of the proposal, though Congressional approval appeared very unlikely. The official Washington stance on allowing dollarization to evolve into a reciprocal relationship has been quite non-committal. There are few pronouncements, either in favor or against. One exception was Under-secretary of the Treasury John Taylor’s testimony on Argentina. He suggested that the bank deposit freeze might have been avoided if they had moved to a different exchange rate system: “moving away from the peg toward solid dollarization or if
23 you moved to a flexible…I at that point in time thought that dollarization would have been good for Argentina…I wasn’t recommending that. Because, as I said, U.S. policy, it’s for the country to choose” (Taylor 2002, 21-22). Although the testimony was nuanced, newspapers in Argentina headlined it as recommending dollarization. Cohen(2002) has assessed the arguments in favor and against U.S. support for dollarization. His conclusion is that “Unless directly challenged by efforts elsewhere to establish formal currency blocs, the United States has no interest in promoting a wider role for the greenback”(p. 1). “U.S. policy has remained cautiously neutral—a strategy of ‘benign neglect,’ to borrow a phrase from an earlier era. Governments considering dollarization may be given moral support, and perhaps some technical assistance, but otherwise are left more or less on their own”(p. 7). This suggests the next step in de-dollarizing. Serious investigation of establishing a regional currency should become public policy building on prior work on regional currencies, both in the Mercosur and in the Andean Development Corporation. If the current relative weakness of the dollar continues, the U.S. may be willing to pay more attention to this possible challenge to its monetary hegemony. If Europe were interested in supporting such initiatives, the attention of the U.S. could be further focused. The growing power of China’s yuan could combine with Japanese interest in an East Asian currency union to provide another challenge to the dollar (Yokokawa 2003). These efforts should also be contextualized by changes in international capital markets. There has been a dramatic shift in foreign investment toward China and away from Latin America. There are growing challenges to international capital markets, ranging from Argentina’s default to the implementation of capital controls in Venezuela. It is not at all clear
24 that these steps will radically change the balance of negotiating power. However, they can serve to support, or at least to provide cover for, a de-dollarization process. It is important to take these steps long before any effort to de-dollarize is initiated, for a successful change in policy could only occur if there were widespread understanding and support, and if it was undertaken “purely” on technical grounds. If de-dollarization were attempted in the midst of a crisis, it would be a short run failure because its costs would be quite high. So careful groundwork must be laid and the case must be made convincingly that the economic performance of Ecuador would benefit from de-dollarization. Other elements supporting this argument are the failure of Argentina’s convertibility project and the mediocre performance of El Salvador and Guatemala, along with the unwillingness of the U.S. government to make the relationship reciprocal. The battle of public opinion polls is already being waged. The Chamber of Commerce of Quito claims that polls showed over 60 percent of Ecuadorians favored dollarization.8 On the other hand, the results of a poll by IESOP (2002) indicated that 65 percent of those polled in Quito and 62 percent in Guayaquil felt that dollarization had been negative for the country. Fifty-seven percent in both places felt that a return to the sucre would be beneficial. What actual steps must be taken to restore the domestic currency? The most obvious is that the Central Bank would have to be preserved and indeed strengthened. This contradicts Schuler (2002) and other proponents of dollarization (de Ginatta, 2001) who have argued that the Central Bank should be abolished to ensure that government “interference” in the market economy be prevented. The analytical capacities of the Central Bank must also be preserved and strengthened to allow support for reestablishing a domestic currency and operating a monetary policy that contributes to stability in the domestic economy. 8
Private communication in a seminar in June 2002.
25 Next, credibility on the fiscal side must be established, for if there are fiscal imbalances that would have to be monetized, the effort to reestablish a domestic currency would be dangerous. This remains a major problem in Ecuador. International support for debt relief would be a helpful counter. One of the key factors holding back Latin American economic performance has been the debt overhang that traces its roots back to the 1970s, and which has never truly been addressed. Every government must use large portions of its revenues, often over 50 percent, to service the debt. Any effort to de-dollarize must deal with this problem directly. Argentina’s suspension of international debt payments may have provided a caution to international capital markets that could make debt holders more willing to adjust their expectations and demands on countries that cannot afford the current debt payments. If the international financial system were to accept this reality and allow debt relief, the fiscal pressures would be lessened and the domestic currency introduction more likely to succeed. This once again highlights the importance of the international context in any effort to reestablish the domestic currency. One other change in the international financial system would facilitate de-dollarization. The earlier experiences of countries leaving a currency bloc and reestablishing their domestic currency all took place under a system that supported capital controls. Indeed, they were built-in so that there was no “trilemma” of economic policy. Fixed exchange rates and independent monetary policy were the goals of the policy framework. Now, allowing the currency to float will strengthen domestic monetary policy. However, in the absence of capital controls, it is entirely likely that the currency will depreciate rapidly and engender further instability. International acceptance of the possibility, indeed desirability, of capital controls would facilitate the effort to break the hard peg and reestablish a national currency.
26 Having laid a domestic basis and with some degree of international support, how could Ecuador actually de-dollarize? The process must be carefully thought through and gradual, and a different model of development must accompany it. The goal must be to reactivate the economy and create employment, using available political-economic space and resulting in sustainable development In summary, it would take creative political/economic leadership to pull together a viable approach to de-dollarizing. There are clear benefits that could accrue to Ecuador. There are also significant risks in the effort.
CONCLUSION Despite the widespread belief that de-dollarization is impossible, there is reason to believe that such a policy is feasible, though the path toward its realization is complicated. The real question is what the costs would be and whether it could be accomplished without chaos. The paper showed what benefits Ecuador gained by dollarizing and how it might maintain that program. On the other hand, there is good reason to feel that the de-dollarization option will have to be considered in the future. The dimensions to that decision and the elements that might facilitate its success were considered in the last section. There is no guarantee that de-dollarization would be more successful than dollarization. The final outcome would depend heavily on the type of international support that Ecuador was able to gain for the step. In addition, only if the underlying political and economic contradictions of the country were fully addressed would de-dollarization succeed. The paper has laid out the many considerations in any effort to de-dollarize and has contributed to the on-going discussion. It remains for Ecuador and its policy-makers to negotiate these difficult shoals. They should
27 realize that the current is carrying them in that direction and they cannot simply ignore that reality.
28 Table 1 Ecuadorian Macro Performance, 1997-2002 EXTERNAL SECTOR Exports, mm$ Imports, mm$ Current Account, mm$ Emigrant Remit., mm$ Capital-Fin. Account, mm$ Foreign Direct Inv., mm$ Foreign Debt, mm$ Foreign Debt/GDP Reserves, mm$ Reserves, months FISCAL, %GDP Revenues Expenditures Fiscal Surplus Primary Surplus MONEY SECTOR Inflation, annual % $ Exchange Rate-Dec Devaluation, % Money Base Growth % M2/GDP Domestic Loan Rate, % Domestic Deposit Rate, % Sov. Debt Spread, bp. Moody Debt Rating Real Exch. Rate-‘94=100 REAL SECTOR GDP, mm$ RGDP, 2000$ RGDP, $ per capita Real GDP Growth, % Investment/GDP Saving/GDP Urban Unemployment Real Wage Index
1997
1998
1999
2000
2001
2002
5,264 4,520 -427 644 -2.0 723 15,099 63.8 2,093 5.6
4,203 5,109 -2,001 794 1,459 870 16,400 70.5 1,698 4.0
4,451 2,736 877 1084 -1,342 648 16,282 97.6 1,276 5.6
4,926 3,400 920 1317 -6,607 720 13,464 85.1 1,180 4.2
4,678 4,936 -550 1415 918 1330 14,410 68.5 1,074 2.6
5,029 5,953 -1,177 1432 1,000 1275 16,287 67.0 1,004 2.0
19.9 22.1 -2.2 2.1
17.3 22.1 -4.8 2.4
21.1 25.0 -3.9 3.4
25.9 24.4 1.5 4.7
24.7 24.0 0.7 0.8
26.1 25.3 0.8 4.2
30.6 4,428 21.8 31.6 30.9 14.0 9.4 597 B1 97.6
36.1 6,825 54.1 41.2 32.5 13.4 9.0 1,334 B3 97.1
52.2 20,423 196.6 174.0 23.2 18.0 12.3 2,754 Caa2 137.0
96.1 25,000 23.5 -58.1 29.7 17.1 9.5 1,435 Caa2 147.3
37.7 25,000 0.0 15.7 23.1 16.4 7.1 1,186 Caa2 106.1
12.5 25,000 0.0 5.2 23.7 16.0 5.6 1,794 Caa2 93.1
23,635 16,198 1,447 4.1 17.9 15.4 9.3 116.6
23,255 16,541 1,447 2.1 19.9 13.7 11.8 109.6
16,674 15,499 1,328 -6.3 16.9 20.0 15.1 105.7
15,933 15,933 1,338 2.8 20.4 26.9 10.3 76.0
21,024 16,749 1,378 5.1 21.6 19.8 10.4 105.3
24,310 17,320 1,396 3.4 22.8 19.2 8.7 102.9
Sources: Banco Central del Ecuador, “Información Estadística Mensual,” #1815 (May 31, 2003); Interest Rates: various issues of Banco Central del Ecuador, “Información Estadística Mensual; Moody Debt Rating: : Accessed July 10, 2003.
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