Introduction

The dollarization process of the Ecuadorian economy has captured the attention of students of economic affairs, political leaders, international analysts and the civil society as a whole, during the past couple of years. This discussion gained relevance when the government announced the official decision to adopt the dollarization scheme, on January 9th of the year 2000. Today, two years later, a consensus has emerged with respect to the positive effects that dollarization has had on our economy, both nationally and internationally. Even so, politically biased opinions without a proper technical grounding have persistently made their way into the local press and have given rise to a series of myths about the dollarization scheme and its effects on the economic system.

The history of economic development provides support for the assertion that no society can progress without a healthy monetary system. In Ecuador, dollarization was appropriately chosen as the alternative to introduce a strong currency into our economy. We must clarify, from the start, that no currency exchange system can guarantee, by itself, sustainable economic growth or foster national competitiveness. However, a stable currency is necessary, but not sufficient, to attain sustainable economic growth.

We will contribute to the technical debate through a brief analysis of the history of money, the origins of the dollarization process in our country and the results that have been attained. More specifically, we will describe both the formal and informal processes that drove Ecuador into dollarizing the economy, and describe the impact that it has had on the economic system during the last two years. Finally, we will also refer to the myths that have been created around the dollarization scheme.

2. A brief history about irresponsible monetary policy

"Money," in its different presentations, has existed since prehistoric times. It fulfills an essential role in the development of societies. Its genesis, as in the case of language, is spontaneous and its evolution constant. Our ancestors used the spondylus shell as money, then gold and, more recently, paper money, which became the international accepted form of money. Since ancient times, humans have had the need to identify valuable objects to facilitate exchange, and the primary role of money is precisely that: to facilitate exchange.

Originally, the concept of "paper money" was based on an implicit contractual obligation to pay a debt, usually in the form of gold or silver, against the presentation of a receipt. This form of transaction gained acceptance because it facilitated exchange by making it easy to carry a piece of paper that represented substantial sums of money, instead of carrying heavy pieces of metal. These "contracts" were violated when the rulers mandated that their people had to accept those "receipts" in the place of real money. This made it possible for the rulers to issue "receipts" that could not be converted to their nominal equivalent in precious metal. For example, Kublai Kahn in the thirteenth century decreed that people had to accept his bills or face the death penalty. Today there is no death penalty for refusing to accept a specific currency, but there are laws that play a similar role. The denaturalization of money resulted always in catastrophic economic consequences given the fact that people wanted to protect their gold and goods and stopped using these for exchange, once they realized they were only receiving pieces of paper with no real economic value.

In most cases, governments that printed paper money beyond what they could guarantee with their reserves had a tragic ending. In 1294, the introduction of paper money in Persia contributed to the collapse of commerce. John Law, a prominent nineteenth century Scotsman, persuaded King Louis XV to print paper money in order to expand the French economy. The initial results were promising, but later due to the irresponsible issuing of paper money, the currency lost credibility and Mr. Law was thrown out of the country. During the Civil War, the United States had a very negative experience with paper money that gave rise to huge inflation rates, comparable only to the problems experienced in Germany in 1923.

The Ecuadorian economy has also experienced many crises due to irresponsible monetary policies. We should bear in mind that until the establishment of Central Banks, private banks issued their own bills, which were usually guaranteed by gold and silver reserves. For instance, in 1871 with the first Bank Law, banks were required to have a metallic reserve at least equivalent to 33.3% of the total bill issue, percentage which was increased in 1897 to 50%.

In 1914, the United State’s Federal Reserve system was established to play the role of a Central Bank. Since this event, the concept of Central Bank disseminated throughout the rest of the world, with the result that most countries implemented centralized monetary systems. Professor Erwin Kemmerer, of Princeton University, was one of the most prominent figures that contributed to the creation of Central Banks specially in Latin America. In 1927, he participated in the establishment of Ecuador’s Central Bank and implemented significant reforms to the Ecuadorian monetary system. According to the new laws, private banks could no longer issue their own money and the existing bills that were circulating were substituted with official bills issued by the Central Bank.

Naturally, the concept of Central Bank that Kemmerer proposed in the 1920’s is radically different from the modern concept. The original concept did not last more than four years before its basic underlying principles were violated. The Ecuadorian government decreed, as a consequence of World War I, that the bills issued by the banks could not be converted to their metallic equivalent through the promulgation of the "Ley de Inconvertibilidad Metálica," better known as "Ley Moratoria" in August 1914. Kemmerer was able to re-establish the convertibility of the Central Bank currency through a strict gold standard. The original idea underlying the creation of the Central Bank in Ecuador was the introduction of a strong currency.

At the end of the twentieth century, Ecuador experienced another crisis that was strikingly similar to the one that occurred in the 1920s. The similarities start with the agricultural crises that hit the country with the "escoba de la bruja" (witch’s broom) in the 1920s, which is comparable to "El Niño" in the 1990s. The inconvertibility of the 1920s is equivalent to the deposit freeze of the 1990s; the excess in currency issued of the 1920s, is equivalent to the excess in currency issued in the 1990s and to the popular discontent that resulted in the overthrow of the ruling government in both periods.

In both cases, destructive monetary policies drove the country into severe financial and economic crises making it necessary to modify the prevailing currency exchange system to provide the country with a strong currency. To put an end to the banking crisis of the 1920s, Kemmerer introduced deep reforms to the country’s financial system, one of which was the reinstatement of the gold standard; in the banking crisis of the 1990s the equivalent measure was the dollarization of the economy, which resulted in a radical shift in the orientation of the economy. Moreover, the population received in both cases a new "hard" currency, to commence a new path of economic development. Therefore, we could state that the adoption of the dollarization scheme was the Kemmerer Mission of the 1990s.

3. The drove toward dollarization

The exchange system in which the official currency is not issued domestically, like dollarization in Ecuador, is only one among the many alternatives within the spectrum of possible currency exchange regimes. Ecuador has historically, like most Latin American countries, experimented with a diversity of currency exchange systems, pursuing different macroeconomic objectives. During the last fifteen years, for example, the country has tried out fixed exchange rate systems, crawling pegs, and free and controlled exchange rates, among others.

As we mentioned before, the exchange system has no capacity, by itself, to guarantee economic growth or foster competitiveness; it is only a part of a larger set of economic policies. The effectiveness with which this set of economic policies achieves its goals at the national level will depend, in turn, on the dynamism and efficiency of the productive sector, on the business environment and on the specific political and social realities of the country. Additionally, national economies are subject to external shocks, like the fluctuation of the international price of oil, wars, and natural disasters. Consequently, if our purpose is to gain an accurate understanding of the dollarization process in Ecuador, we must comprehend the context in which different economic policy measures were introduced and how they contributed, initially, to an informal dollarization of the economy and, later, to the formal dollarization of the economy in January of the year 2000.

Informal, formal and real dollarization of the economy

The Ecuadorian dollarization process can be divided, at least, in three stages. First, an informal dollarization process, in which the economic agents voluntarily replaced their deposits, investments and holdings in sucres with their equivalents in dollars; this process evolved during the whole decade of the 1990s. Second, the official government announcement to formally adopt the dollarization scheme, which took place on January 9th 2000. And finally, the process of exchanging all of the remaining sucres in the economy with dollars, which ended in the month of December 2000.

The informal dollarization process started approximately in 1990. In that year, practically all of the deposits (99.9%) and of the quasimoney (92.5%) in the economy were denominated in sucres. In 1996, almost one quarter of total deposits (23.8%) and of quasimoney (28%) were already dollarized. In January 2000, when the government made the official announcement of the dollarizatation scheme, the economy was already dollarized in more than 60%, without taking into account deposits in off-shore banks. This is a fact that is worth highlighting because the official decision was merely of a political nature and only ratified the decision previously taken by the economic agents. (Graph 1. and Table 1.) Of course, the government’s decision gave an additional momentum to a process that had already reached a significant momentum before the state’s intervention. By December 31st 2000, the exchange of sucres for dollars had been accomplished in 97.4%. We could say, then, that real dollarization of the economy was completed only one year ago. (Graph 2.)

Graph 1. – Informal Dollarization

 Informal Dollarization 

 Graph 2. – Exchange Process

 4. Results of dollarization in Ecuador

With dollarization, Ecuador has adopted an economic policy that assures economic agents that the government will never again make use of an irresponsible currency issue either to promote productive activities or currency devaluation as a competitive tool. This decision is based on more than a thousand years of international experience and more than a century of national experience. Devaluation can not provide sustainable competitiveness and it has always meant that the benefit of a few is financed by the larger unprivileged population.

The belief that devaluation can foster competitiveness is based on a mercantilist vision of the eighteenth century that assumes that wealth is fixed and cannot be augmented. To put it differently, the "economic pie" is supposed to be of a fixed dimension that could be distributed differently, but could not be expanded. If this assertion were true, we could not explain the empirical fact that the world has consistently improved the living standards of their citizens through productivity growth.

Everyday we witness how innovations make life easier for all of us and significantly improve the well-being of the population. With each new exchange, the "pie" grows larger, thus denying the assertion that the gain of one party results in a loss for the other one; instead the case is that both parties can win. It is definitely not a zero-sum-game. On the contrary, devaluation does not create wealth; it destroys it.

Under these new "rules of the game," Ecuador faces the challenge of creating new wealth through a free market economy, where the price system effectively sends out clear signals about the general functioning of the economy. The dollarization scheme has unquestionably transformed the Ecuadorian economy into a real economy.

The application of the dollarization scheme has generated very favorable macroeconomic results. These results have attracted the attention of most analysts, but we must emphasize that there are many positive results of the new exchange system that are not captured by the macroeconomic indicators.

Dollarization in Ecuador proved to be an essential measure to attain macroeconomic stability and to lay solid foundations for future economic growth. We have an expanding economy: our GDP grew at a rate of 5.4% during the last year, which was the highest growth rate in Latin America. The construction sector grew 19.9%, retail commerce and tourism 7.7% and industry 5.5%. For this year, we expect GDP to grow between 4.5% and 5%, where most of the growth will come again from the construction sector that is expected to grow at15.1%, the oil and mining sectors at 4.5% y telecommunications and infrastructure at 4.2%. (Graph 3.)

 The improved tax collection reflects the recovery of the economy, increasing from $1,300 in 1999 to $2,300 million in 2001. This is primarily due to three factors: First, under dollarization income taxes do not loose their purchasing power, in contrast to what happened with the sucre devaluations in the past. Second, the recovery of the economy is reflected on GDP growth and tax collection. Thirdly, the IRS has improved its efficiency in tax collection through a better control of evasion.

Graph 3. –GDP Evolution, 1991-2003

Since dollarization, there is a growing confidence in the financial system that is captured by the historical evolution of banking system deposits, which grew significantly, from a level of approximately $3,000 million to the current level of $4,800 million. (Graph 4.)

Graph 4. – Banking System Deposits

The reduction of the inflation rate has been, without doubt, the most important social achievement of dollarization. The average inflation rate has dropped from 60%, in 2000, to 23%, in 2001 and to 16% in January 2002, and our goal for 2002 is to reach a single digit inflation rate. (Graph 5.) Under dollarization there can be no new currency issue, and we expect that the price adjustment that started two years ago will conclude this year. It is a known fact that the dollar price levels in some sectors of the economy have not reached their equivalent of prices expressed in 1998 sucres. In the sectors where there is no lag in price adjustment, the 1998 sale volumes, in most cases, have already been reached. The one idea that is worth stressing is that Ecuadorians can be confident that the distortions introduced by high inflation rates are vanishing.

Graph 5. – Evolution of CPI and PPI

Another positive result of dollarization that is not sufficiently publicized is the recovery of the purchasing power of the household income that Ecuadorians have experienced during the last year and a half. The index of coverage of the household basket of goods has improved by 100% since the dollarization scheme came into effect and during the year 2001 it reached the highest average coverage of the last five years. Our goal, is to move from our current level of coverage of around 70% in 2001, to a coverage in the order of 100% in 2003. (Graph 6.)

Gráfico 6. – Coverage of Household Basket of Goods Index

These positive results as well as the improved confidence in our economic system have been reflected in the increase of the price of our Global Bonds and in the consequent reduction of our country risk. Since October 2001 and after the presentation of our Economic Agenda in official forums, such as the IMF and WB meetings in Ottawa, and investor meetings in Washington and New York, the prices for our external debt bonds have picked up significantly (16% in the Global Bonds). This performance is still more encouraging if we take into account the recessive trend in the international economy, specially after the September 11 events and the effects of the Argentine case. Furthermore, this positive tendency reflects the international confidence in Ecuador and the positive expectations in terms of economic growth that have been recognized by Standard & Poor’s that changed our country’s evaluation from negative to stable. (Graph 7.)

Graph 7. – Evolution of External Debt Bond Prices

For the first time in 18 years, Ecuador successfully completed an agreement with the IMF. The IMF recognized the country’s achievements and approved a final disbursement of funds ($96,000,000) by the end of 2001. The over-achievement of the targets approved with the Fund will facilitate the negotiation of a new agreement for 2002, which has started by mid-January. This is a precondition for future negotiations with the Paris Club.

As we mentioned above, macroeconomic stability is not the greatest impact of dollarization in our economy. The greatest impact takes place in the process of expectations and in the transparency with which economic agents can conduct their transactions. In short, the greatest benefits are focused at the microeconomic level and it is at this level where we should concentrate our future efforts.

Ecuadorians now conduct their businesses in a real economy and they must face the up to the challenges that a real economy imposes. Transaction prices accurately reflect economic reality and give out clear signals to the economic agents, because prices are no longer altered by inflation. A hard currency allows us to evaluate and detect economic disequilibria. For example, we are able to clearly analyze the speculative process that we experienced in Ecuador during the month of January. Speculative processes are not compatible with a market economy. These processes can only arise in the presence of distortions in the competitive structure. If we define a market as competitive, unilateral speculation of an agent will not result in economic profit. But the speculative process that occurred in January was real, thereby we must recognize that the products and services in which prices were raised are not produced in a competitive market, with the exception of those products and

services that are subject to cyclical fluctuations. As a consequence, given that we have eliminated monetary distortions, we must now center out attention on improving competition at the industrial level, competitiveness at the national level, to attain efficiency of the overall economy.

According to the detractors of the model, dollarization in Ecuador is the same as convertibility in Argentina. Nothing could be farther from the truth. Ecuador is not Argentina and dollarization is not convertibility.

The convertibility model of Argentina was able to reduce the volatility of macroeconomic indicators and reduced inflation, but it did not take into account that once stabilization was attained, it was required to implement both structural changes and strict fiscal discipline are required.

During the first years under the convertibility scheme, Argentina grew thanks to the external resources that arrived because of the increased confidence in the system, but the productive structure remained unaltered, while both the external debt level and government expenditure grew rapidly. This disequilibrium is reflected by the size of external debt as opposed to exports. In order for Argentina to pay its external debt it would be necessary to use the equivalent of seven years of exports. In contrast, Ecuador would only need two and a half years of exports.

Convertibility in Argentina is a "sui generis" monetary model whose collapse was due to its inherent lack of credibility, because it was never an "orthodox currency board". Excessive debt at the state level and the mishandling of resources liberated by the privatization process contribute to explain the collapse. Additional government policies added to the lack of credibility. For instance, the hidden devaluation that took place with the application of a preferential exchange rate in international trade (8% more for exports) in June 2001.

The essence of what caused the Argentinean problem Ecuadorians already know; fiscal disequilibria cannot be corrected with deposit freezes, which constitute a violation of the citizens’ private property rights. These type of measures never produce economically efficient results.

 Trade Account, Capital Account and Balance of Payments

Some analysts blame dollarization for the trade deficit and argue that this is a negative result. When an economic agent expects that his/her future income would expand significantly, he/she would increase current consumption. Put differently, the economic agent would finance current consumption with future income. Similarly, if an economic agent were willing to lend money to another one, he/she would be working under the assumption that he/she would be able to recover the principal plus the interest. Thus, the lender assumes that the borrower will have the capacity to pay in the future.

This behavior at the individual level is reflected at the aggregate level. When Ecuador’s imports are larger than its exports, other countries both implicitly and explicitly are lending to the country their goods and services, because they are convinced that Ecuador has the capacity to pay its debts. That is why a trade deficit is not negative per se.

In Graph 8., we can observe that during 1999 and 2000 Ecuador had significant Capital Account deficit while at the same time it had Current Account surpluses.

 Graph 8. – Evolution of the Balance of Payments

Devaluation and Competitiveness

Some critics claim that dollarization has a negative impact on exports and competitiveness, arguing that our exports become more expensive everyday because our international competitors can apply exchange rate devaluations as an instrument to improve their "competitiveness". This is another myth that has no economic foundation.

Devaluation is a short-term measure that unavoidably leads to a generalized domestic price increase, annihilating any artificial price competitiveness gained through devaluation. This is a classic example of the "fallacy of composition." Moreover, devaluation does not generate a sustainable advantage and it makes it difficult for a country to change its competitive strategy from an easily imitable low price strategy to a high quality based strategy, originated on higher value added.

It is important to highlight the fact that when exporters benefit from devaluation, there exists a large number on non-exporters, whose income and financial assets are denominated in local currency, who will be negatively affected by the measure. This way the benefit of a few is achieved through the detriment of many, who are usually the financially unprivileged citizens that have no access to dollars. In sum, competitiveness that is based on devaluation is not sustainable and it has a harmful effect on the overall economy; but it is particularly detrimental for the poor.

The Ecuadorian case provides empirical support for these assertions. Between August 1998 and January 2000 the exchange rate moved from 5,000 to 25,000 sucres for one dollar, a 400% devaluation in a one and a half year period. This measure, according to the myth, should have transformed Ecuador into one of the world’s most competitive countries, but, as we all know, this did not happen.

Dollarization is not to blame for the recent fall in Ecuador’s exports; the political instability of the first two months of 2000 had a terrible effect on exports, even though the real exchange rate had reached a high level. Similarly, there are other factors that affect exports: international prices, commercial barriers, non-commercial barriers, exogenous shocks and nature, interest rates, etc. Under dollarization we must eliminate all of the distortions that work in detriment of exports and, thus, negatively influence the economy as a whole.

The Government is committed with the improvement of national competitiveness. For this reason, a National Competitiveness Agenda was approved and it’s primarily focused on the reduction of "Ecuador’s Cost." More specifically the increased competitiveness will result from the reduction of country risk and the active interest rate, real improvements in the productivity of the private sector, and the elimination of distortions, in general.

 Sustainability of the model

In non-academic circles and among some analysts and politicians the possibility of abandoning the dollarization scheme is frequently discussed. We must stress that the cost of abandoning our current scheme would be enormous and would face many technical difficulties. This is why according to the government and most of Ecuadorian citizens, the dollarization of the economy is a "one-way road."

To return to a domestic currency would open the doors to "new currency issue" and "devaluation." Economic agents would immediately be suspicious of the value of the new currency and a de facto devaluation would occur. That is the reason why Ecuadorians would never willingly accept a new domestic currency, in place of the dollars they now posses.

 Devaluation would, in turn, lead to an increase in the value of private sector debt, expressed in domestic currency, and lead to subsequent problems for the financial system debtors who receive their income in the national currency. Moreover, these trends could lead the country once again into a severe financial crisis.

For these reasons, the cost of abandoning the dollarization scheme would be incalculable both in economic and social terms. We consider that the attack to the dollarization scheme only contributes to create confusion in the general public, because a new currency would lead the country to chaos.

In sum, for any practical purposes, we could argue that the dollarization process is of an irreversible nature, unless we were willing to pay the costs of a crisis of a larger dimension than the one that we experienced two years ago, and even worst than the one that Argentina is experiencing today.

 The future of the economy, not of dollarization

The dollarization scheme never aimed to be the solution to all of our country’s economic problems; it helped us to eliminate some of the disequilibria that had existed in our system for a long time. Dollarization does not constitute a universal remedy nor is it a magic potion that would eliminate all of our problems. Although we have achieved important progress, there is still much to do; our system is not perfect, but all Ecuadorians agree that our future efforts should be focused on fostering growth and the integral development of our country.

The future of our country lies in the development of our economy and in the foundations on which both our country and our people stand. We must work together to improve the competitiveness of our productive sector and in the stimulation of the circular flow of the economy, now that with dollarization we have taken a definitive step toward a real economic system.