Andean Integration and dollarization:
Some reflections about Ecuador’s case
Presentation by the Chairman of the Board of Directors of the Central Bank of Ecuador, José Luis Ycaza, at the seminar "Ecuador’s dollarization and its effects on Andean subregional trade," held at the CAN General Secretariat headquarters

Lima, August 25, 2000

Objectives and Interest

This presentation brings together some ideas and reflections about:

The impact of dollarization on Andean trade from Ecuador’s viewpoint; and

The future goals of the Andean Community of Nations, particularly with regard to the viability of the projected Andean Common Market planned for the year 2005.

The interest in this subject can be traced to the sweeping changes made by Ecuador in its monetary and foreign exchange systems in January 2000 because of the worsening of a series of fiscal, monetary, and exchange imbalances.

Ecuador’s Central Bank has given direct support to the start-up of the economic dollarization scheme, which is designed to strengthen the economy in the short term.

The new exchange system seeks to work a favorable change in the expectations of economic agents, boost investments, and encourage more foreign capital inflows, amidst radical social reforms.

Integration continues to occupy an important position within this context. To Ecuador, however, it is even more significant than a few short years ago, for the country embarks upon that integration in the midst of sweeping structural changes.

It is my intention here to show you that dollarization works as a stimulus to continue conquering the subregional market on the basis of increased productivity and competitiveness, which would in no way require longer periods or protectionist attitudes.

In my opinion, dollarization does not, as could be assumed, constitute an obstacle to the attainment of the Andean Common Market targeted for the year 2005.

What are really important in this approach are the common strategy that the subregion will define to move toward its attainment, together with the political will for doing so.

In this presentation, I will analyze:

I. Ecuador’s trade experience with the CAN: the trade liberalization program, II. Ecuador’s dollarization, III The objectives of the new model, IV. The new model and Ecuador’s trade with the CAN, and V. Some reflections about dollarization and the Andean Common Market, and VI. Conclusions.

I. Ecuador’s trade experience with the CAN: the Liberalization Program

The country’s trade relations with the CAN have been strengthened since the beginning of the 1990s due to agreements that were reached in a series of meetings held in the area, among them, those of Cartagena (1989), Galápagos (1989), and Macchu Picchu (1990), which made it possible to move ahead more rapidly with trade opening and liberalization.

Complementary to the reduction of tariff levels, provisions for streamlining export formalities were issued at the level of the Andean market and a series of trade and integration agreements were signed.

Ecuador’s exports to the CAN as a percentage of its total exports rose from 6.54% in 1990 to 13.0% in 1998 and 10.8% in 1999, while its imports from the CAN surged from 9.7% of its total imports in 1990 to 17.5% in 1998 and on up to 20.3% in 1999.

Ecuador’s exports to the Andean area in 1990 represented 63.3% of its total exports to the LAIA. That level held in 1998 (62.4%) and dropped slightly in 1999 (58.2%)

On the other hand, Ecuador’s imports from countries in the Andean area accounted for 43.8% of its total LAIA purchases in 1990, 57.4% in 1998, and 60.1% in 1999.

The country’s exports to Colombia amounted to 1.2% of the total in 1990, 6.7% in 1998, and 5.1% in 1999. In the case of Peru, the 5.2% share in 1990 rose to 4.7% in 1998, and declined to 4.0% in 1999. Even so, there are encouraging signs that the trade flows with the latter country could increase.

In the case of its imports, the importance of the Andean market as a supplier to Ecuador has increased sharply, from a very poor 5% at the close of the 1980s to 20.3% in 1999.

In 1999, trade with the area declined heavily because of Ecuador’s and Colombia’s troubled economic situations. Total exports to the CAN in 1999 amounted to US$ 482.5 million.

Imports from Colombia, the country’s main trading partner, rose from 3.1% in 1990 to 10.6% in 1998 and on up to 12.0% in 1999, while in Venezuela’s case those percentages declined slightly from 5.1% in 1990 to 4.8% in 1998 and then increased to 6.4% in 1999.

The intra-Community balance of trade has been negative for Ecuador over almost the entire 1990s, reaching a negative figure of US$ 428.2 million in 1998.

The cited evolution of Ecuador’s balance of trade reveals that its imports have generally outweighed its exports within the CAN, showing it to be a country with a strong demand.

In short:

Despite Ecuador’s recurring deficits, the CAN has proven to be a very important trade area for that country in recent years.

The free trade area with Bolivia, Colombia, and Venezuela, in particular, has made the rapid growth of trade possible, as a result, above all, of a significant increase in the competitiveness of national producers.

The rate of exchange was not revealed as the most important element for boosting that growth.

II . Ecuador’s dollarization: some background elements

A. Deterioration of macroeconomic aggregates

Ecuador’s economy deteriorated heavily starting in 1998 and worsened in 1999 due to a series of internal and external elements: the presence of El Nino, the drop in oil prices, the domestic and international financial crises, and the growing fiscal deficit.

In 1999, the real GDP slumped about 8% and the nominal GDP shrank by almost 30%, reflecting the conspicuous decline in investment and private consumption. Unemployment virtually doubled in only twelve months, reaching 16% in December 1999.

The annual inflation in consumer prices picked up from 43% at the end of 1998 to 91% in February of 2000, and producer prices snowballed from 35% to 301%. The sucre was devalued almost 200% in 1999 and a further 25% in the first week of January 2000.

The total public debt increased substantially, from 64% of GDP in 1997 to 118% in 1999. The heavy fall in GDP was responsible for the drastic rise in this ratio. By the end of the year, the deficit of the non-financial public sector had reached a level of almost 7% of GDP.

In August 1999, the Government temporarily suspended the payment of debt service on Brady bonds and Eurobonds.

It also rolled over roughly US$500 million in short-term domestic bonds in order to extend their maturities and lower interest rates.

B. Deepening of the banking crisis

The deterioration of the economic situation accentuated the problems of the banking system, produced, on the one hand, by the macroeconomic deterioration and, on the other, by the practice of certain banking institutions to grant loans to bank-associated borrowers.

Also contributing to the situation was the failure to supervise with strictness, particularly extra-territorial operations.

In December 1998, the Government created the Deposit Guarantee Agency (AGD), with the mandate to reorganize the banking system and announced that it would guarantee all domestic and overseas deposits and foreign trade operations of the banking system.

On January 1, 1999, a 1% tax on financial transactions was introduced, adding to the problems of the banks by triggering substantial financial disintermediation.

A bank run resulted in the decreeing of a bank holiday from March 8 to 12, 1999 and a freeze of six months on savings and demand deposits and of one year on term deposits. Bank portfolios were rolled over.

In August 1999, the Government began to unblock a large part of the demand and savings deposits, completing the process by January 2000. It would appear, however, that a substantial number of these deposits, made in United States dollars, have flown overseas.

In October 1999, considering the deterioration of their operations, the AGD stepped in and merged or put three of the four banks that had been recapitalized under administrators.

By January 2000, the overdue portfolio amounted to 43% of the total loan holdings, in comparison with 9% at the end of 1998, and the banks’ foreign credit lines had been reduced by half.

The banking crisis affected the country’s monetary policy in 1998-99. The Government had issued US$1.4 billion in bonds to enable the AGD to recapitalize the troubled banks, pay the deposit guarantees of the banks that were shut down, and cover the withdrawals of the balances owed to foreign creditors.

Close to US$1.2 billion in bonds were discounted by the Central Bank. Inasmuch as the bank of issue was unable to freeze the entire increase in liquidity that resulted from this action, the annual growth of the base money accelerated heavily from 41% at the end of 1998 to about 136% by the end of 1999.

Faced by sustained pressure on the foreign exchange rate and dwindling international reserves, the BCE in February 1999 left the sucre to float freely.

The pressure on foreign exchange rates intensified in November 1999; interbank interest rates shot up from roughly 60% to around 150%; and the Central Bank increased the minimum cash ratio on deposits in sucres. Even so, these pressures did not let up and on January 9, 2000, the intention to dollarize the economy was announced.

To date, the Banking Board, the body headed by the Banking Superintendent, and the AGD, have taken over the administration of 14 financial institutions (among them, the country’s largest banks), which account for approximately 65% of the system’s domestic assets. The owners lost their capital.

To sum up:

Ecuador had had no comprehensive economic program to offer a scenario favorable to private investors since 1995.

This played a large role in building up the negative expectations of economic agents, for whom the public administration lost credibility, and this was expressed in extreme foreign exchange volatility.

The country had shown absolute inconsistency in the application of public policies for macroeconomic regulation, leaving the application of a more rigid model –dollarization— as the only possible alternative.

III. Objectives of the new model

The objectives of the new model are:

To reduce inflation to more moderate levels by progressively bringing prices into line with international levels.

To reach a higher rate of growth by cutting down the inflationary and exchange risks. This would encourage more saving, reduce interest rates, and boost foreign investment.

To strive for more discipline in economic management, for the Central Bank can no longer finance public spending by issuing more currency.

To bring down interest rates, inasmuch as dollarizing would reduce the inflationary premium in interest rates, moving them closer to international levels and eliminating the exchange risk.

To conclude this section:

The new exchange system would involve changing the logic behind economic management, for it would do away almost completely with the capacity to make monetary policy and would make economic growth dependent upon the capacity to generate foreign exchange.

It accordingly calls for making an effort to be more competitive and, therefore, giving continuous support to processes that contribute to increased integration and trade liberalization. In practice, the tendency of the economic cycle will depend hereafter on the balance of payments position.

On being dependent on foreign exchange earnings to underpin its economic growth, Ecuador must strengthen its position in the international market and thereby ensure an increase in its foreign trade. In this connection, it will give its support to economic opening and the efforts to make the region’s trade flows more dynamic.

It should be pointed out that empirical studies made on Ecuador’s foreign trade (the determining elements of its exports and imports) have found that policies of economic opening and the level of the cycle of activity are essential. Variations in the rate of exchange would be only one of the less important variables.

IV. The new model and Ecuador’s trade with the CAN

The dollarization scheme would be advantageous to trade within the Andean subregion for the following reasons:

i) Dollarization allows economic agents to define planning horizons for their mid-term investments and incentivates their participation in export projects because foreign exchange rate volatility is eliminated.

ii) The need to ensure a continuing flow of foreign currency into the economy, which calls for a greater willingness on Ecuador’s part to accept a trade opening, would be favorable to its trade with the subregion.

iii) With the elimination of restrictions in the new model, it encourages adjustment from the import side during economic upswings.

iv) The economic growth that would be attained as part of the dollarization system would fuel the growth of trade with the CAN, inasmuch as the level of economic trade is directly tied in with the level of growth, as already explained.

v) Greater economic discipline would have a favorable impact on the expectations of economic agents, reinforcing savings and investment activities and thereby promoting the domestic demand, with consequent benefits for the growth of trade.

In short:

Dollarization would have positive effects for Ecuador in its trade relations with the CAN.

There are also three aspects of the lessons to be learned from successful experiences with international trade that Ecuador is heeding at the moment:

i) The importance of having a stable macroeconomic environment, including real rates of exchange that are stable, predictable inflation, and sustainable balance of payments deficits. The macroeconomic environment must be fully predictable. Governments must therefore adopt macroeconomic management policies that enable exporters to forecast the courses to be taken by the key variables and, on that basis, to sign contracts, open letters of credit, and make assumptions with regard to their future costs.

ii) The need to apply complementary policies that are consistent.

iii) The importance of implementing export promotion programs based on market mechanisms and systematic striving for competitiveness that will allow exporters to react calmly to changes in the external demand.

V. Dollarization and the Andean Common Market: some reflections

A. Andean Common Market and monetary area

It is common knowledge that one of the most ambitious challenges facing the CAN in the next few years is to establish an Andean common market by the year 2005, a target set by the Andean Presidents at the Ministerial Meeting held in Cartagena, Colombia in May 1999.

In the present economic circumstances, Ecuador attributes unmistakable priority to integration, for it considers that the risks of globalization and the increased interrelationship and interdependency of economies worldwide may be cushioned by more cooperation and concerted policies for moving macroeconomic regulation in the right direction.

Several events contribute to the conclusion that the other Andean countries may share this priority. The intention to move together toward a one-digit inflationary target and the desire to encourage macro-fiscal harmonization are examples of this.

Attempts at policy harmonization, however, have been very limited within the integration movement, affecting trade and finance and the monetary and exchange spheres. Efforts are now focusing on reaching agreed options within a pre-defined process of approaches, if the final aim is to create the Andean Common Market and monetary area.

From Ecuador’s viewpoint, the change in its monetary model is not, as could be assumed, an obstacle to the formation of the Common Market.

On the contrary, it will contribute to that aim because it is conducive to the harmonizing of economic policies more easily and lays a sound groundwork for monetary management and total integration, as we will see further ahead.

In today’s international economy, there are a series of circumstances that must be carefully evaluated before reaching the conclusion that local currencies must be kept always.

In a world of large international banks and mammoth international corporations, there is, perhaps, little room for monetary independence, except in a few large countries. It is also impossible to conclude that stabilization depends inevitably on the existence of flexible exchange rates vis-à-vis fixed exchange rates, for example.

This complicates the vision of the Common Market, in terms of how, ideally, it should function in the subregion, inasmuch as the implicit problems involved in forming it (stability conditions, transaction costs, transportation costs, welfare implications, and factor and capital mobility) must be evaluated under assumptions that in the present situation differ from those on which classical literature on the subject are based.

What is true, considering that the subregion’s key final objective is to arrive at a single currency, is that the countries must be convinced that they:

i) wish to align themselves with the rate of inflation existing in the monetary area; ii) want to reduce transaction costs in their trade with the most important trading partner; iii) hope to eliminate the cost of printing and maintaining separate currencies; iv) agree to participate in the "purchasing power parity area" that can be sustained by fixed exchange rates, and even more so in the monetary area; v) seek to establish a policy anchor –that is to say, a fixed point around which the expectations of economic agents can be formulated and economic policies can be organized; vi) aim to eliminate the discretionary power of monetary and fiscal authorities; vii) want to keep the exchange rate outside the sphere of politics and of vested interests wishing to devalue the currency to increase their gains or pay off their debts; viii) intend to set up an automatic mechanism to reinforce monetary and fiscal discipline; ix) seek to have a kind of multinational "cushion" to absorb shocks; x) want to share the political decision of deciding on a rate of inflation inside the monetary area; in short, xi) that they will allow the improvement of internal monetary and fiscal discipline to be delegated to an external mechanism; and xii) seek to strengthen or establish an economic power bloc that will have a larger specific weight in international economic discussions and in that way will lead to an improvement in their terms of trade, among other things.

In light of the foregoing, some elements may arise for which the countries would not necessarily be willing to lose their monetary sovereignty. Mundell summarizes them, pointing out that that decision would be influenced by the fact that the potential partners:

i). may wish to maintain their own rates of inflation, different from that of the area;

ii) may seek to use the exchange rate like an economic policy instrument in order to raise or lower wages and also to attract jobs away from the other countries;

ii) may not want to share the potential benefits of the union or to face macroeconomic imbalances that could be worsened by those participating in the area;

iv ) may not agree to stop benefiting from seniority;

v) may not want to eliminate the possibility of financing the tax office;

vi) may not wish to eliminate areas of general sovereignty, among other things.

Thus, from the theoretical viewpoint, no major doubts remain regarding the advantages of forming a common monetary area, a situation inherent to the Common Market.

Nonetheless, we should not forget that behind all of this lies the fact that the objective calls for a large degree of coordination, particularly on tax matters, which brings to mind a further reflection.

In effect, in the world of optimum monetary areas, as well as in several reports on the role played by public finance in European integration, for example "a large degree of centralization [of coordinación]... of national fiscal policies is advocated so that [the] budget…can act as a mechanism for reestablishing the macroeconomic balance in the event of possible biased disruptions, thus making it possible to reduce the social costs inherent to a recession."

Fiscal policy becomes a highly attractive instrument in the degree to which a country’s adherence to a monetary area involves abandoning monetary and exchange policies for purposes of stabilization.

Nonetheless, the margins for maneuver of fiscal policy-makers may, above all in countries like the Andean, be subject to several influences: experience has clearly revealed the negative effects produced by fiscal laxity on interest rates, public and private investment, and general macroeconomic performance, revealing the full importance of defining objective criteria for policy coordination.

The foregoing underscores the need for a prior rapprochement, in which, more important than the subject of foreign exchange, is, face-to-face with the common objective, defining the preconditions for making the operation of the Common Market and of the monetary area viable.

In practice, I agree with the Central Bank of the Argentine Republic when, on referring to the subject, it points out that "the creation of a [subregional] currency would involve at least a prior process of macroeconomic rapprochement through criteria that are probably stricter than those of Maastrich, largely because our countries are more vulnerable to crises, suffer from more institutional weaknesses, and have capital markets that are little developed."

The question that arises, then, is what would that single currency, the currency of the Andean Common Market, be?

Alternatives could be explored that in no way would commit the countries at this point. For Ecuador, for example, that role could be played by the United States dollar, which is effectively the currency that is already most used in the region and which enjoys the necessary credibility.

Perhaps the subject could even go beyond the subregional sphere at the proper moment to take in the entire region: it is a well-known fact that the negotiations for the formation of the Free Trade Area of the Americas, FTAA, are moving ahead as scheduled.

Nonetheless, it should be clear that what is essential at this stage of discussion is the political determination and will to begin the process of macroeconomic rapprochement and dovetailing and to define the possible ways of alleviating the biases that a process of this kind generates.

The crux of the matter is not indicating as of this moment that the common currency should be the U.S. dollar or that the countries should create their own currency; a decision will have to be made about the matter later, in light of the elements projected by the existing international monetary configuration and the future of today’s strong currencies, the dollar and the euro, among others.

Perhaps the greatest benefit to be obtained from moving toward a single currency based on a scheduled rapprochement, is the elimination of uncertainty. This benefit, which has been obtained by Ecuador thanks to the adoption of its new monetary and exchange model, should be extended to the entire region, for it is perhaps its most important advantage is anticipating the creation of a monetary area and of a subregional currency.

It is now time to redirect our efforts in accordance with that goal. Perhaps we have spent too much on developing models and procedures for prediction, obtaining predictions, and discussing alternative policy lines of action and too little on political and institutional design and working out rules to cut down on uncertainty.

B. Some reflections

I will start off by pointing out, lastly, that mistakes in economy policy are very costly for countries. Ecuador has certainly experienced this fact at first hand in recent years, but today is looking toward the future with optimism.

Over the past decade, the international economy consolidated the trend toward the growing interdependence of national economies through a variety of vehicles: a significant increase in the international trade in goods and services; growing capital flows; stronger links and more dependency among financial systems; a growing interrelationship between economic growth and technological development; and the pulling down of trade barriers, to name only the most important.

This has been borne out, despite the periods of turbulence faced by the international economy in the course of these years, one of which –perhaps the most serious— was the recent Asian crisis.

As the case may be, what is true is that experience has shown that a stronger positioning and opening to the world is positive for the countries, above all because it makes it possible to increase the competitiveness of national products and to allocate resources more effectively, thus producing positive pressures on economic growth, employment, and investment.