After 20-Plus Years of Dollarization, Ecuador Is Better Off

Last week, I returned from an unforgettable vacation in Ecuador. I truly had a wonderful time. I enjoyed multiple natural sites, including a volcano, a rain forest, and a crater lake. I also got to enjoy the wonders of Quito, which is one of the original UNESCO World Heritage Sites. Aside from learning the differences of the Spanish language across countries, one of the other things I got to learn about was the history of Ecuador's monetary policy. 

In 1884, Ecuador took on the currency known as the sucre, a currency that was then linked to the silver standard until 1898 when it switched to the gold standard. To jump forward, the International Monetary Fund established a purchasing power parity in 1946 of 13.5 sucres to the U.S. dollar. Things were relatively stable until 1983. To deal with the devaluation, Ecuador adopted a crawling peg. Things went from bad to worse, from 42 sucres to the U.S. dollar in 1983 to 3,000 sucres in 1995. Ecuador's financial crisis of 1998-99 led to hyperinflation of the sucre, which resulted in a 95 percent devaluation of the sucre. Then-President Jorge Jamil Mahuad Witt to announce in 2000 the adaptation of the U.S. dollar as Ecuador's currency to deal with the rising prices and devaluation. How has the Ecuadorian economy fared since dollarization? 

Pros of Ecuador's Dollarization

1. Macroeconomic stabilization. Considering what the Ecuadorian economy was experiencing up to the 1998-99 financial crisis and the path towards hyperinflation that Ecuador was on, this was a major plus. Ecuador has enjoyed price stability that it has not seen at least fifty years prior to dollarization. Since 2005, Ecuador's consumer price index converged to that of the United States, and has not gone beyond 5 percent. Even when Ecuador had fiscal expansion between 2008 and 2014, it was able to do so without inflationary consequences.

2. Improved macroeconomic credibility. Using the United States as a monetary anchor meant a more credible monetary policy. Because of dollarization, Ecuador needed to create a list of priorities within its balance sheet to "limit monetary financing of the central government (ADF)." This credibility also improves long-term investment and trade prospects in comparison to the sucre. 

3. Lower risk premia. Because of the improved credibility and stabilization, there is unlikely to be steep currency devaluation. This makes it easier to access international financial markets. It also makes it a lot less likely for capital flight. 

4. Elimination of transaction costs. Since Ecuador is dealing in dollars, it becomes easier to business in the international marketplace.

5. Development of financial sector. This is another outcome of the credibility and low risk premia. Since there is greater funding for investment, greater economic growth is an end-result. This economic boost translates into more money for the poor, which means less income inequality. 

6. By most metrics, the lives of Ecuadorians improved. Dollarization resulted in higher incomes for Ecuadorians, thereby increasing the GDP per capita (Macrotrends). Unemployment and poverty rates fell. Infant mortality rates did not increase. 

Cons of Ecuador's Dollarization

1. Ecuador cannot be a lender of last resort. When Ecuador underwent dollarization, it lost control of monetary policy, which means the Ecuadorian central bank cannot be a lender of last resort. This loss of control was clear during the global financial crisis of 2007-09 when Ecuador's central bank lost its independence. During this time, it had to lend to the government, which dwindled Ecuador's foreign reserve. Although the central bank cannot act as a conventional "lender of last resort," the central bank of Ecuador has used a Deposit Insurance Scheme and a Liquidity Fund that build liquidity buffers.  

2. Inability to handle foreign shocks. This is another issue with relinquishing control of monetary policy to the U.S. Federal Reserve. If there is a global recession or a major trading partner has an economic downturn, Ecuador's central bank would have little recourse to deal with it since it cannot use interest rates to maintain the currency. There would need to be a greater reliance on fiscal policy (e.g., higher deficits, higher taxes). Conversely, if a central bank's policy is ineffective or has lost credibility, then this lack of control is negligible. 

3. Loss of seigniorage. Seigniorage is profit made by the government making currency, which is the difference between the value of the currency and their production costs. The revenue losses experienced are both in terms of the initial replacement of the currency and the "flow" costs related to future earnings from the flow of new currency. 

Conclusion

Dollarization was an extreme policy response to an extreme situation of its financial crisis. Like with so much policy, there are advantages and drawbacks. For one, we need to compare the costs of external monetary shocks to the costs of domestic monetary shocks. More importantly, we cannot compare to what an idealized version of a central bank could look like in comparison to the current dollarization because that would fall under the Nirvana fallacy. Looking at Ecuador's monetary policy from 1983 to 1999 specifically, as well as the history of monetary policy in Latin America more generally, strongly suggests that there was no viable alternative to dollarization in Ecuador. Policy is not about choosing an idealized version, but is choosing the best, or in some cases, the least worst, option. The reason why Ecuador chose the dollar was because there was such institutional weakness in its monetary policy to begin with. 

I was in Ecuador watching the presidential primary elections. Given that there were 18 candidates and that there were a lot of populist tropes throughout the campaigning, I wouldn't trust that Ecuador could provide a viable alternative to dollarization at this time. If left to its own devices, it would be more likely that the debt-to-GDP ratio would skyrocket even more than that of the United States currently is. I don't think that dollarization is a silver bullet with the capacity to cure Ecuador's macroeconomic woes, much like it wouldn't be if Argentina were to dollarize (read Mercatus Center analysis here). Aside from the structural issue in which Ecuador's economy is highly dependent on oil exports, it could be argued that dollarization is needed before a country passes more deregulation, freer trade, or balancing the budget. Even if it was not, the aforementioned reforms would be necessary to help complete Ecuador's transition into a developed nation. In short, based on the data available, Ecuador's dollarization was the best option, certainly at the time and still remains their best option. 

Major Sources

• Álvarez Vásquez, Carmen et al. Revista Científica Dominio de Las Ciencias. Cost-Benefit Analysis of Dollarization, Ecuador Case. October 2018. 
• Banco Central de Ecuador. Información Estadística Mensual No. 2026 - Diciembre 2020. December 2020. 
• Banco Central de Ecuador. Índice del Boletín Anuario Número 42, 2020.
• Cachanosky, Nicolas and John Ramseur. American Institute for Economic Research [AIER]. 20 Years of Dollarization: A Synthetic Control Analysis, September 2020.
• Cueva, Simón and Julián P. Díaz. University of Chicago. The Case for Ecuador, January 2019.
• Özyurt and Cueva. L'Agence Française de Développement [AFD]. Twenty Years of Official Dollarization in Ecuador: A Blessing or a Curse?, August 2020.
• Wang, Sam. Council on Hemispheric Affairs. Examining the Effects of Dollarization on Ecuador, July 2016.