On A Roll: Ecuador's gamble with the U.S. Dollar

12/Marzo/2013 | 16:24

By Lance Brashear

Special to the International Edition

QUITO – Ecuador’s Law of Economic Transformation, which made the U.S. dollar the nation’s legal tender, has lived up to its name by any measure.  Since the adoption of the dollar in 1999, the country’s economy began rising from the dead and today the population of 15 million has never had it so good.

Yes economists are increasingly nervous about how long the good times will last.

Enacted during a crisis of inflation, currency devaluation, and the closure of 70 percent of the country’s financial institutions, the dollarization law came not a moment too soon.

Exporter Andrew Reitz said of the time, “It was crazy. I remember going to the bank every day and seeing the exchange rate going up and up and up and it was killing the local economy.”

The crisis drove 3,000 companies to bankruptcy including the family textile business of Anne Mejia.  “It broke us,” she recollected.  With devaluations almost daily and clients who paid her 30-90 days later she said, “by the time we got our money it was not worth as much.”

Those in charge of managing the Ecuador’s economy aggravated the crisis by printing money at a reckless pace. Marco Naranjo, a former chief economist at Ecuador’s central bank, says Ecuador printed more bills in 1999 alone than in the preceding 70 years. 

But the new law ended the crisis by eliminating the former currency, the sucre, and formalizing the "dollarization" of the banking system.

Since then, economic life in Ecuador has improved dramatically.  Among the indicators are real GDP growth and relatively low inflation alongside declines in unemployment and poverty. 

“Everyone is happy with the dollar,” said Katherine Soto, whose family has managed a local sandwich business in Quito for more than 60 years.  “People feel more secure,” she said.  

She, Mejia, and Reitz know no-one who wants to return to a local currency.

Still, many economists fear Ecuador’s economy could face eventual catastrophe, warning that dollarization is sustained completely by the high international price of oil.  They point out that the dramatic rise in petroleum prices, which have seen a 10-fold increase since the late 1990s, has coincided with dollarization. Oil revenue is now responsible for 40 percent of the state´s income, while economic production in other sectors has stagnated.

Economists also point to what they believe is the precarious management of the nation’s finances, in particular its low foreign reserves.

Should a crisis materialize, even pro-dollar economists agree, the system may come apart.

“The price of oil is what has sustained [dollarization], nothing more,” says Luiz Maldonado, former president of Ecuador’s Federation of Exporters, and a former production minister.

Maldonado was also the coordinator of “Foro Ecuador Alternativo,” a group of business leaders and economists, including Rafael Correa, the current president, which fought dollarization.  They believed a switch to the dollar would diminish export capacity and ultimately fail because of a lack of local production.

But Ecuador’s overnight conversion to the U.S. dollar seemingly restored public confidence and calmed the nation almost immediately.  Dollar supporters, including Naranjo, do not attribute the mood change to oil.

“If you look at petroleum it was not so high at the beginning, yet there was a process of formidable investment recovery,” said Naranjo.  He argued that dollarization has been sustained because the country was forced to adopt a new, productive mentality.

Maldonado questioned that assertion. From growing bananas to pumping oil, “the number of products with added value is practically zero,” he exclaimed. “Where is the entrepreneurial spirit?”

When Ecuador renounced its own monetary policy it also gave up the ability to devaluate its currency, a traditional mechanism for increasing exports and stimulating production.

But in an interview last year Fernando Pozo, general manager of Banco Pichincha, Ecuador’s largest private bank, dismissed devaluations as a crutch. “The only way to sustain a process of exportation is through productivity.”

Central bank data demonstrates a growth in exports and real GDP since dollarization, but the Institute of Economic Investigations at the Catholic University of Quito recently provided an analysis showing that as a percentage of GDP, most economic sectors have actually contracted, including oil and mineral production.

Though petroleum revenues are higher, the increase has been due to higher prices and a significantly larger share of oil dollars for the state thanks to expropriations and forced renegotiations with multinationals. Oil production has remained essentially flat for a decade at 500,000 barrels a day.

And as the price of oil has steadily climbed so have public expenditures, alarming economists.

Public investment in Ecuador in 2012 was $5.7 billion or about 11 percent of GDP, driven in large measure by state-sponsored construction.  Public sector payrolls have swelled while private sector trade has become heavily distorted. 

Oil dependence has increased the country’s non-petroleum trade deficit 10-fold to more than $8 billion since 2000.

Former Finance Minister Mauricio Pozo commented in an interview last year, “Public expenditures have increased at such a rhythm that if tomorrow the price drops to $20 we are going to have a grave problem that could threaten dollarization.” 

If Ecuador were forced to abandon the dollar and adopt its own currency, say economists, including President Correa, the result would be an unprecedented crisis.  At the 10th anniversary of dollarization Correa said, “To leave dollarization would be a social and economic cataclysm.” 

What would happen?

Economists offer this view: The introduction of a new currency would cause confidence to plummet and lead to an immediate run on the banks.  In turn, banks would freeze accounts, paralyzing the financial system.  The new currency would have to be devalued almost immediately, impoverishing the country and returning Ecuador to a system of speculation.

But Naranjo maintained that a planned exit from dollarization is theoretically feasible citing the example of the Dominican Republic that “de-dollarized” in the late 1940s after decades of using U.S. currency. “We can leave dollarization if we can acquire a very good [foreign] reserve,” he said.  Naranjo estimated the country would need twice the amount of money in circulation, or about $50 billion.

Ecuador’s international foreign reserves hover around $3 billion.

The Ecuadorean Association of Private Banks has publicly expressed nervousness with the reserve levels managed by the central bank, worried that an external economic shock (such as a drop in oil prices or natural disaster) would obligate the government to spend private deposits to manage a crisis.

Ecuador’s central bank did not comment for this article.

As Ecuador gambles on the price of oil over time, Diego Aulestia, former head of the Banco del Estado, a state bank, argued that it might pay off.  “I believe that one must be careful about the dependence on natural resources, but more importantly is what you do with the money that comes from those resources,” he said.

Aulestia pointed out that Ecuador has been investing heavily in hydro-electric projects, oil refineries and roads, while also strengthening human capital with education programs that mandate state service.

Though these measures will improve productivity they will take years to realize.  A crisis, on the other hand, could occur overnight, precipitating, many argue, the collapse of dollarization.


Ciudad Quito

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