Two decades of the U.S. Dollar: Ecuador's experience

By Sonja Rijnen-

A man buys U.S. dollars from a street money changer in Quito, Ecuador, Jan. 11, 2000. Source: Bernetti, AFP

In the year 2000, Ecuador formally adopted the U.S. dollar as its official currency. This meant that all wages, prices of goods and services and transactions were converted to the U.S. dollar, eliminating the sucre as the legal tender. Put simply, this radical measure known as dollarization was implemented in an effort to overcome major economic woes. In the late 1990s, Ecuador went through a severe economic crisis with inflation rates soaring to 96.1% in 2000. This, combined with low oil prices and big public sector wage increases, meant that the value of their currency fell dramatically causing capital to flow out of the country. Many Ecuadorians started to use the dollar to avoid losing their purchasing power, kickstarting the government’s process of officially dollarizing in the hope of putting an end to the downward spiral of Ecuador’s economy.


There are various known economic advantages to dollarization; a key one being (re)gaining faith from foreign investors. Investors are likely to feel more confident in investing money in a country that has a stable currency so that they can be assured that the value of their investment will not be drastically reduced with fluctuations in exchange rates. More investment often leads to a more stable capital market and an end of major capital outflows, helping to stabilise a country’s economy. Dollarization may also facilitate international trade because there is a reduction in transaction costs as buyers can purchase goods in a currency they already hold (i.e. the U.S. dollar). Finally, dollarization will likely help countries integrate into the global economy, something that is often said to aid development and economic growth.


However, in the global economy you can’t have it all. Dollarization by nature entails a huge sacrifice: the loss of national monetary autonomy. Countries can no longer print their own money or set their own interest rates thereby largely losing some abilities to influence their domestic economy. Countries that dollarize have to take the interest rate set by the U.S.’ central bank- the Federal Reserve. This can be problematic as the Fed does not consider the situations of external countries that have dollarized when implementing monetary policies. Countries can also no longer use the useful tool of “competitive devaluation” (strategic depreciation of a currency to make exports more competitive on the global market) in times of economic hardship, as they must accept the exchange rate set by a foreign central bank.


It should be noted that, despite the fact that the loss of monetary policy autonomy is largely considered a disadvantage, there are many who argue that the elimination of a national currency forces government deficits to be financed through fiscal policies (such as taxing or debt accumulation) which are much more transparent methods compared to controlling money supply through printing money (an option that is no longer possible when an external currency is adopted). This is important because, in Ecuador and most other Latin American countries, central banks are not independent of the executive branch of government, as they are in the U.S., but rather are agencies of these. This means that, through dollarization, governments are no longer able to use monetary policies as political tools. They can't implement an overly aggressive expansionary policy that may have short term advantages and help to win an election but can have long term damaging effects on the economy. In this sense, dollarization eliminates the moral hazard and prevents politicians from using monetary policy for personal gain.


So, two decades on, how has dollarization manifested in Ecuador? In the short term, dollarization worked. Inflation lowered (although somewhat slowly and rates did not reach the low figures as those in the US), currency instability ended, and financial markets stabilised. Since dollarization, Ecuador has boasted an average of 4.4% in annual economic growth, partially due to the benefits that dollarization has had on sectors such as finance, transportation, communication, tourism and hospitality, as well as Ecuador’s oil industry. All of these sectors benefited from higher rates of foreign investment and the facilitation of international transactions which made international trade and globalisation easier. Ecuador’s largest trading partner is the U.S., and exports to this country have increased substantially since the adoption of the dollar.


Unfortunately, the story is somewhat different when it comes to more local sectors such as agriculture and other industries that cater to the domestic economy. Over the last decade, the U.S. dollar has mainly appreciated (increased in value) compared to other local Latin American currencies. A big implication of this is that Ecuadorian products have become much more expensive than those in neighbouring countries. Every day, thousands of Ecuadorians travel to Peru and Colombia to purchase goods at much lower prices. Food, cars, TVs, to name but a few, can cost half the price abroad. This has become a rising problem in Ecuador and many industries have suffered due to the fall in domestic demand. In fact, Ecuador’s former president, Rafael Correa, called upon Ecuadorians to support national production and purchase domestically made goods.


Aside from the various benefits and pitfalls dollarization has brought to different sectors of Ecuador’s economy, proponents of dollarization in Ecuador have also indicated that the country has not faced a large economic crisis such as those seen in Argentina and Venezuela since adopting the dollar, arguing that the reason behind this is that those holding political power can no longer use monetary policy as a tool or print money when they so desire. In his article for the American Institute of Economic Research, Nicolas Cachanosky (2020) writes that he believes Ecuadorians mainly see dollarization as “an institutional feature first, and as a monetary policy tool second”. He argues that Ecuadorians were and still are worried about the prospects of a populist leader financing large expenditures and many believe that dollarization has prevented Ecuador from becoming the next Venezuela. In sum, although there are sacrifices made in terms of monetary policy autonomy, many believe the institutional benefits outweigh these.


However, this argument is also debatable. Dollarization did not fully curb expansionary fiscal policies in Ecuador and government spending increased from 20% of GDP in 2000 to 44% in 2014, a statistic that is very high especially when compared to neighbouring countries. As the government cannot print money, it has financed its spending through debt, causing Ecuador’s debt to GDP ratio to increase substantially. The government has taken measures against this through taxation policies but, although dollarization can prevent governments from exploiting monetary policies, it does little to control fiscal policies and a rising government budget.


The question remains whether or not Ecuador is ready to de-dollarize. Those that believe dollarization is not just about monetary policy, point to the fact that monetary policy problems stem from institutional weaknesses which dollarization solves. They argue deep institutional reforms are needed before Ecuador can safely re-introduce a domestic currency to ensure that the incentives of policymakers are kept in check. Many also point out that a large problem is Ecuador’s over-reliance on its oil exports and that before this is tackled de-dollarizing would be irresponsible. Although two decades of dollarization has taught Ecuador, and the rest of the world, many lessons about the effects of adopting the dollar, the jury is still out as to whether it has caused more benefits or draw-backs for the country.

 

Bibliography:


https://latinamericanpost.com/20279-is-the-dollarization-a-viable-solution-for-latin-america#:~:text=Dollarization%20was%20the%20radical%20measure,the%20formalization%20of%20the%20measure.


https://www.usnews.com/opinion/blogs/eric-schnurer/2014/05/02/why-ecuador-and-other-states-dont-use-their-own-money#:~:text=It%20just%20uses%20the%20U.S.,unofficially%20dollarizing%20the%20country's%20economy.


https://www.aier.org/article/dollarization-in-ecuador-after-20-years/


https://www.coha.org/examining-the-effects-of-dollarization-on-ecuador/