Latin American dollarization processes
Presentation by Dr. Liliana Rojas-Suárez, Director of the Deutsche Bank Securities of New York, at the seminar "Ecuador’s dollarization and its effects on Andean subregional trade "

Lima, August 25, 2000

It is always a pleasure for me to come to Lima to discuss issues like this one. This is not the first time, nor, I believe, will it be the last, for this is a subject that will be under discussion for some time because of the importance of the process involved and the differences of opinion that exist over the dollarization approach.

There is no doubt whatsoever that the subject of Latin America’s dollarization has taken on special importance since Ecuador’s turn in that direction. I’m going to analyze the aspects that are favorable to and against dollarizing and, I’m going to explain why, from my point of view, I believe that in untroubled times –that is, when there are no crises— Latin America, in general, is not yet prepared to undertake dollarization.

This does not mean that I do not recognize the enormous benefits to be gained from dollarizing in terms of increased efficiency. Obviously, as we are all aware, no Latin American country is in a position to issue debt instruments in its own local currency. In fact, it cannot even trade in its own currency. Therefore, having a currency that will allow it to carry out its transactions, both commercial and financial, represents a gain in efficiency.

There is another point to be made that is even more important and this is that no long- term loans are made in local currency. In almost all of the countries of the region, long-term loans are extended in dollars, although in recent years the region has been moving financing away from the dollar and toward the euro. But that’s another subject. As I was saying, the loans are arranged in foreign currency, but the projects –normally the payment of salaries, wages, taxes, and so forth— are paid for in local currency. This creates a very large mismatch between assets and liabilities on the financial balance sheets of not only banks, but also companies. Getting rid of this mismatch also means making an important gain in efficiency, and I admit this very definitely.

The fact is that I do not think this is the right moment to dollarize. What I do believe is that it is important to move, not necessarily toward dollarization but, rather, toward a common currency. However, there are basic restrictions in effect at the moment that may simply keep dollarization or moving toward a single currency from working. I am going to go into this subject more fully and then I will center my thoughts on the problems and benefits to the Andean Community of Ecuador’s dollarization and its general status.

In the first place, I think that too much importance is being given to exchange risk in the region. Interest rates in the region are far more dependent upon country risk than exchange risk. Ecuador is dollarizing, but its spread is internationally the region’s highest.

In the second place, Latin America is one of the world’s groups most open to shocks in terms of trade and volatility of capital flows. This is a known fact and needs no further explanation because the volatility is there for all to see. It is a matter of simply adjusting the relative prices between tradable and non-tradable goods. This can be done in many ways: one is by adjusting the exchange rate; another, by adjusting domestic prices or through economic growth. To my way of thinking, it is more costly to do this in a dollarized economy.

The third aspect that I’d like to bring out here refers to the three requirements to be met if dollarization is to work properly, if it is to be implemented and remain in effect without being abandoned. And finally, I believe that for most of the countries in the region (and throughout my presentation I am going to speak of the majority, because exceptions do exist and one cannot generalize), the most beneficial combination for a country is a flexible exchange rate and a large stock of international reserves. This sounds like a contradiction in terms when discussed in economic textbooks, but I’m going to delve a little further into the subject to show you why there is no contradiction.

My first point is that country risk is crucial. This has a lot to do not only with the internal economic performance of countries, but also with the evolution of the international markets. What happened in the 1990s was a movement toward bond issues, away from dependency on bank loans; but the fact is that the bond market and the market for bank loans are very different. Banks can get together and form groups that can deal easily with situations of non-payments or of delays in international payments. In the bond markets, however, there is still no international body –what is called a bank bankruptcy – that is to say, an international bankruptcy agency that will make it possible to mediate between countries and the international market in some way or another. As a result, bondholders are extremely sensitive to changes in the countries because if they are not paid, they have no one to turn to. This makes country risk the dominant variable and is the reason why, at the slightest sign of a problem in a country, investors immediately react, leave, or charge very large profits because they feel they are taking an unusually large risk.

Moreover, precisely because the countries are much more open –which is an advantage, but also a restriction--, every time the country risk increases, domestic interest rates rise also. The reason for this is very simple. With the rise in the cost of international currency –and by the way, that is precisely what is happening today--, when a country needs financing at a given moment (for I need financing today, and just because its cost will rise tomorrow doesn’t mean that my need for financing will decrease), it will have to diversify its financing from outside financing to inside financing. That is what is happening in the region and that is why there is so much talk about developing pension funds when what is actually wanted is domestic financing. Then obviously, because the capital markets are not very developed and the need for financing becomes pressing, the domestic interest rate rises. As a result, the relationship between what happens outside the country and what happens inside couldn’t be clearer and has absolutely nothing whatsoever to do with the exchange rate. What is important is the country risk.

Many people claim that when a country has problems with its exchange rate, its country risk increases basically --in other words, that the effect moves from the risk of devaluing to the risk of not paying and on to the country risk. I agree that a relationship exists, but that tie-in is precisely the opposite. I believe that what happens when a country experiences domestic problems, or when international investors believe that it does, whatever that risk may be, what is immediately perceived is that the country’s capacity to repay, irrespective of whatever that may be, drops. If I experience a negative shock, a shock in the terms of trade that affects my exports, I will obviously have fewer resources to be used for making payments, and that clearly impairs my country risk. When that happens, the international private sector begins to make trouble over what is called the "rollover" –the existing debts. Then what happens? The country begins to spend its international reserves merely to meet the payments it must make. With this drain of international reserves, the domestic economy –the people in the country— begin to believe that the exchange risk is increasing and, in effect, the fear grows that local currency may devaluate. But where does this all begin? With the country risk, not the risk of devaluation.

Sovereign Yields & Real Interest Rates

Here, we have an example in this graph of three countries, Argentina, Brazil, and Mexico, where the straight, unbroken line shows the local interest rate in real terms. The other is basically an indicator of the country risk obtained by measuring international spreads.

There are two interesting things I would like to show you. The first is the convergence of these two lines in the three countries. But the more important thing is that in Argentina’s case the two lines are together. Argentina’s case is significant because the convertibility process has been underway in that country for several years now. If what I am measuring are the real domestic interest rate and the country risk, we can see that the country risk runs very close to the real domestic interest rate, despite the fact that at the moment there are no major expectations that Argentina will abandon its convertibility. The point I would like to make here is that a consistent decline in the real domestic interest rate depends far more on a decrease in the perceived risk of investing in a country than on fluctuations in its exchange rate.

Exchange rate fluctuations are normally short-lived. For example, look at Brazil; do you see that peak? Well, the peaks form when speculation runs rampant. This is the exchange rate. You can see that the interest rates rise heavily to try to defend the exchange rate, but then they return to their normal places because the situation is not permanent. But the country risk, however, is.

The second point I would like to make is that the Andean Community countries, like all of the countries in the region, are subject to major shocks in both their capital flows and their relative prices due to the shock in terms of trade. These are two extremely important restrictions that exist in the region. An effort must be made to ease them, for so long as they exist, it will be very hard to achieve the stability we are looking for. In fact, it is almost impossible when a country at any moment simply ceases to have access to the international markets. And it is almost impossible to consistently carry out an investment program by drawing on domestic resources alone.

To repeat, these restrictions are very heavy and they exist right now. This, then, is merely an adjustment in the supply and demand. When there is a shock in the terms of trade or a sharp exodus of capital, it is like cutting the pie, making it smaller; it is a drop in the net transfer of resources from abroad and a decreased demand for the country’s non-tradables. This means then, that the relative prices of those goods must come down, with or without dollarization, with a flexible exchange rate or what have you. It is a real effect, not a monetary effect. The question to be asked is: which is better? From the experiences I have observed, it is my impression that the adjustment is far more costly when the exchange rate is fixed or when it is dollarized.

The second graph again shows three countries, this time Mexico, Argentina and Peru. The black line represents the dollar rate of exchange and the broken line is the country’s relative prices in relation to the international prices. As you can see in Argentina’s case, with a fixed rate of exchange, the country had to absorb the shock via deflation. Is that deflation still continuing? Have real wages and salaries dropped? Unemployment continues to decline and the Argentine government is in an enormous quandary because it does not have enough tools to give the economy the boost it needs.

Mexico and Peru, for their part, as the only countries in the region with flexible exchange rates before the Asian crisis, were the countries that weathered the crisis most rapidly and whose growth was least affected. In Peru’s case, however, either that growth has been insufficient or else there is not enough investment. Whatever the case, the fact is that they were less affected by the crisis than the rest of the countries. The reason for this is --as you can see, the black line fluctuated– it allowed for that adjustment of relative prices. I won’t say that this is the only element involved. All I mean is that if we compare the evidence among the different countries, we can see that Argentina at this moment does not have instruments it needs.

I’m now going to refer to the prerequisites for dollarizing in untroubled times. Why do I say untroubled times? Because in times of crisis, everything goes and I think that’s why Ecuador decided to dollarize.

In untroubled times, I generally experience no crises, though one could arise. Here, what is essential is the absence of problems with stocks of international reserves. What do I mean by this? Inasmuch as I consider country risk to be the most important of the risks faced by the country, if, being dollarized, I have a debt that is seen as unpayable –whether it is international or domestic does not matter, just that I owe too much--, the immediate thought that comes to the mind of the foreign investor is that if the economy is stable, I will continue to be paid, but what will happen at the appearance of the first shock? Where will the economy get the funds to continue paying me? The most likely answer is that the economy will launch a program with the International Monetary Fund to provide it with the international resources for paying me.

Therefore, in the face of a problem with my stock of international reserves, the confidence of the international market will be extremely important if I am unable to adjust my real exchange rate in order to produce the foreign currency I need.

The same thing happens in the case of a weak banking system. Here, also, there is a problem of stocks, because a weak banking system is capable of causing a banking crisis, which in our countries always ends up as a contingency for the fiscal accounts. Once again, the question arises. If I have a weak banking system, where will I get the resources I need to resolve the crisis? In fact, if I am dollarized, what central bank is going to help me as a lender of last resort? Because I can assure you that the Federal Reserve will not.

In my judgment, the winning combination is exchange rate flexibility and abundant international reserves. That is what I see as the course that Latin America should take in the short term, in the case of countries that are not experiencing any crises, but that are simply paying their bills day-by-day.

Basically, the major difference between the industrialized countries and those of Latin America is that the former always have access to the international markets, while the Latin American countries do not. Because our region faces more restrictions, it needs more instruments.

Another interesting point is that for the developing countries, exchange rate crises have not meant losing their access to the international markets. This is a highly important difference. There have been countless crises. You may remember the European crisis of 1992, which basically involved the devaluing all of the currencies in that region, but those countries never lost their access to the international markets.

Many times, when we study simple models in economics, we are told that if one has a flexible exchange rate in place, it is no longer necessary to accumulate international reserves because the variations in exchange rate will bring about the full adjustment to obtain the international reserves that are needed for a return to a balanced economy and that plentiful international reserves are required, on the other hand, when the exchange rate is a fixed one.

This is all very good and well, but the fact is that those books are written in the United States and the analysis does not consider the Latin American phenomenon and the restrictions in terms of its lack of access to the international capital market. Just imagine for a moment that a country has a certain debt level and suddenly it experiences a shock. At that moment, it has a flexible exchange rate in effect and it does what is correct by leaving the exchange rate free to find its own level. The level of its international reserves, however, is not going to rise immediately, nor can its exports double from one day to the next.

The reason why a country has to have a large stock of international reserves is because this is the only thing that will give the international market confidence that it will continue to be paid despite the shock. If the country were to have perfect access to the international capital market, then its problem of reserves would be much smaller.

Ecuador obviously does not fulfill the requirements I have mentioned for dollarizing. It is experiencing problems of all kinds with its reserves; it has a banking crisis –one of the largest in the region; it has debt problems not seen since the 1982 moratorium… What do I think, then, about Ecuador’s dollarization? There are two aspects to be considered. On the one hand, dollarizing means adding an anchor, and that anchor is the fixed rate of exchange. It should be recalled that stabilization programs based on exchange rates have worked very well in Latin America during periods of hyperinflation. There are many examples of this: in Mexico, in Brazil, in Argentina.

The dollar, at whatever its value, but always a fixed one, is an ideal element for eliminating inflation and I’m confident that Ecuador’s inflation will be heavily reduced. It has been brought down in all of the countries in the region that have followed programs of this kind. Therefore, while Ecuador does not fulfill the requirements for dollarizing, it does the requirements for adding an anchor, because it has no anchor.

Now then, to my way of thinking, dollarizing increases certain risks in a country where crisis is not a concern, but in a country that is already in crisis, if that dollarization creates a consensus for accepting reforms that would otherwise not have been adopted, it could prove to be an interesting step.

However, my belief that country risk is the basic problem of the Latin American countries is borne out in Ecuador’s case. The stopping of payments by that country has kept Ecuador’s spreads at extremely high levels so that it will have very little access to international capital markets for some years to come.

With regard to Ecuador’s dollarization and its effects on the rest of the Andean Community, I think that there are positive and negative elements to be considered and that it is not easy to reach a verdict.

I am going to make my analysis in relation to two types of trade: external trade –the trade with countries outside the CAN— and the trade with the CAN countries themselves.

In the case of trade with third parties –those not included in the CAN--, try to imagine what will happen if Ecuador suffers a negative shock in the future. Not now, in the future. What will happen? Obviously, it cannot devalue. Therefore, Community countries that export goods similar to those of Ecuador will not become less competitive. That effect is positive for the countries and is in sharp contrast to the example of the Asian crisis. One of the problems in that region which worsened the crisis was precisely the fact that when Thailand devalued its currency, all of the countries exporting similar goods became less competitive. It is clear, then, that if Ecuador has a negative shock, the rest of the countries will not become less competitive, because Ecuador cannot alter the value of its currency.

On the other hand, however, if another Community country devalues its currency heavily, this will impair Ecuador’s competitiveness, because Ecuador cannot adjust its relative prices and here we are talking about goods that compete with each other. The good news, at least in the short term, is that inasmuch as oil is one of Ecuador’s most important exports, so long as the price of oil stays high, this effect will not be very important.

The impact on the economic activity between the members of the Andean Community in this case will depend upon whether or not their economic cycles coincide. In the case of a recession –a fairly common occurrence in the region—the dollarized country could benefit enormously if the exports of other Community members were to rise sharply. In other words, if their economic cycles did not coincide with its own.

In 1995, Argentina benefited tremendously from Brazil’s growth following its implementation of the Plan Real in 1994. Then the "tequila effect" spread and Argentina was affected by the effect of another country not located within its trade bloc; the growth of its trading partner, Brazil, however, was extremely beneficial to Argentina.

The same thing can happen in Ecuador’s case. If Ecuador faces a recession at a given moment, while its trading partners are growing, this can cushion the negative effect of the shock on Ecuador. However, in this last example, Colombia, Ecuador’s most important trading partner, will not experience positive effects because the two, Ecuador and Colombia, share the same economic cycle.

Argentina and Brazil, by the way, are now in a similar situation. Argentina is not benefiting from Brazil as it did in 1995 because Brazil experienced a small recession as well, from which it is only now recovering. In fact, there are many who think that Argentina will leave its recessive problems behind only when Brazil takes off again completely.

You can see here how important it is to have a trading partner that is growing, but also note that Brazil has a flexible exchange rate. As a result, Brazil benefits from that flexible rate and grows and, in growing, drags with it Argentina, which cannot alter its exchange rate.

Lastly, there is another effect that Mercosur is facing at this moment and that theoretically increases the Andean Community’s risk. This is that if at any time I need fiscal resources, if I need resources of any kind with which to pay my debts and am unable to produce them because I cannot adjust my exchange rate, there is the risk that I will consider raising customs tariffs to generate income.

I say this is a risk because there is a group of economists in Argentina today who are proposing this as an alternative for Argentina in Mercosur’s case. People in Argentina are aware that the last thing Argentina will give up is its convertibility, not Mercosur as its first target. The thinking is that if a situation arises from which there is no escape, the choice will be to leave Mercosur, rather than to abandon the country’s convertibility. This would constitute a risk only if by putting myself in a straight-jacket, by having few or no alternatives for securing resources, I were to consider the possibility of raising tariff funds.

With this idea, I rest my case. The message I want to give you is not that I am against any single currency. I believe in a single currency and that, in effect, the world is going to move toward a few currencies, rather than many, because that would be very inefficient.

But it is also true that many reforms, many good ideas have been doomed to failure simply because they were not properly implemented. Perhaps the clearest examples are the financial liberalization programs that touched off banking crises throughout the region. Is financial liberalization bad? Not at all, but it must be well implemented if it is to work. The same is the case, I believe, with a single currency. The aim must be there, but instead of skipping steps, what must be done is to try to establish the proper conditions, to fulfill the requirements for making the dollarization or the move toward a single currency successful and permanent.