robert looney, teaches economics at the Naval Postgraduate School in California.
Published tk, 2017
To those unfamiliar with the mysteries of international financial gambits, one of the more arcane is one country’s adoption of another’s currency — typically the currency of a dominant trade and investment partner. At the moment, three Latin American countries, all of which have signed on with the U.S. dollar, fit the category.
The Yellow Brick Road
Actually this sort of thing is hardly new. Panama adopted the dollar in 1904, shortly after its independence from Colombia. Almost a century later, Ecuador and El Salvador followed suit, with Ecuador making the switch in 2000 and El Salvador in 2001.
Full-blown dollarization, the path chosen by Ecuador and El Salvador, is at one end of the dollarization spectrum. More often, a country might choose to hold large sums in low-risk dollar-denominated bank deposits and securities to support its currency — or to allow the use of the dollar along with its own currency as a legally sanctioned means of payment and store of value. Regardless of the form adopted, though, dollarization is usually a response to confidence-shattering economic trauma — to hyperinflation (think an inflation rate topping 100 percent) or when fiscal mismanagement leads to large and unsustainable government deficits (say, 10 percent of GDP).
But in a global era of low inflation and hypersensitivity to debt accumulation, it seems to take less to trigger radical monetary transitions. While Ecuador did suffer a serious economic and banking crisis in the late 1990s, its inflation and deficit never came close to the aforementioned panic points; inflation reached 50 percent in 1999, and the fiscal deficit topped out at 5 percent of GDP in 1998.
That, however, was enough to scare middle- and upper-income Ecuadorans, who reacted by shifting most of their wealth into U.S. dollars — which became the country’s de facto currency. By January 2000, the government was forced to recognize the inevitable, formally adopting the dollar as Ecuador’s legal tender.
Dollarization has proven a mixed blessing. Although Ecuador’s rate of economic growth increased from an average of 2.4 percent before the currency shift (1980-99) to just over 4 percent after the shift (2000-15), the good news was probably fueled by the oil boom rather than adoption of the greenback. Similarly, while inflation declined from an average of 37 percent pre-dollarization to 13 percent post-dollarization, it remained well above the rates enjoyed by Ecuador’s major trading partners — a major issue because the differential virtually guaranteed trade deficits down the road.
Modest Benefits, Large Costs
The Ecuadoran government anticipated that full dollarization would lower borrowing costs by eliminating foreign exchange risks (no local currency to depreciate). And, the thinking went, it would force private banks to police their own risk-taking, since the central bank would largely lose its capacity to act as the bank’s lender of last resort.
There proved to be a big downside, though. With the central bank no longer able to create money, the economy’s money supply (and therefore financial liquidity) became dependent on factors beyond the government’s direct control. And recently, liquidity has been vacuumed away by the aforementioned depreciation in the real exchange rate vis-a-vis the country’s trading partners, which has widened the trade deficit. Moreover, with U.S. interest rates beginning to rise, Ecuador faces an ongoing threat of dollar outflows.
Not all of Ecuador’s current economic problems stem from dollarization per se. To remain competitive, facilitate stable growth and allow for rapid adjustment from external shocks, a dollar-based system depends on the flexibility of wages and prices to cushion the blows. And such flexibility in Ecuador would only be possible with labor market reform, increased product-market competition and prudent economic regulation, which have not been forthcoming from the left-wing populist government of President Raphael Correa.
To remain competitive, facilitate stable growth and allow for rapid adjustment from external shocks, a dollar-based system depends on the flexibility of wages and prices to cushion the blows.
In fact, according to the Heritage Economic Freedom Index, Ecuador fell from “mostly unfree” in 2007 to “repressed” in 2016. The World Bank’s measures of governance showed a similar deterioration, while the World Economic Forum’s 2016-17 Global Competitiveness Index placed the efficiency of Ecuador’s goods market at 124th, labor market at 123rd, and financial market at 113th, out of 138 countries. (Switzerland, no great surprise for the Geneva-based WEF, ranks number one.)
Further adding to the economy’s fragility, the government failed to build up fiscal buffers during the heady years of high oil revenues. This led to Ecuador’s 2008 default on its external debt, which shut off Ecuador from international capital markets. Ecuador did subsequently regain market access, but with risk premiums so high as to largely preclude further borrowing at market rates. As a result, the country has become almost totally dependent on China's willingness to provide capital.
Hubris Can Be Costly
Then there’s the case of El Salvador. In contrast to Ecuador, this tiny Central American country suffered no pre-dollarization crisis. In fact, El Salvador managed to stop inflation almost entirely in the wake of its 1980-92 civil war, and it averaged a respectable 4.4 percent growth rate from 1993 to 2000.
But the government thought more was possible and decided that the elimination of currency risk by means of dollarization would step up foreign direct investment (FDI, for short). Indeed, in a moment of hubris, officials envisioned a scenario in which the shift to dollars would effectively integrate El Salvador with the U.S. economy.
Interest rates did come down, but the country found itself facing liquidity problems similar to those of Ecuador when the anticipated boom in FDI never materialized. Instead, FDI as a share of GDP actually declined from an average of 2.2 percent of GDP in the postwar years before dollarization to 1.1 percent in the 15 years since. That makes El Salvador the lowest recipient of FDI in the region.
By no coincidence, average growth fell by half. And despite wide-open access to U.S. markets through CAFTA-DR, El Salvador’s current account deficit has doubled in the past decade, to 4.2 percent of GDP.
A stable currency thus may have been necessary for sustained growth, but it wasn’t sufficient. As with Ecuador, El Salvador’s poor economic performance stemmed largely from deficiencies in governance, especially in rule of law. El Salvador has seen a dramatic increase in violent crime fueled by street gangs, which has more than offset the attraction to investors of lower interest rates and the absence of foreign exchange risk. While scoring significantly better than Ecuador, El Salvador’s record on economic freedom has also been in decline since 2000. And improvements in efficiency have failed to materialize: according to the World Economic Forum, in 2016 El Salvador ranked 122/138 for labor market efficiency, 102/138 for goods market efficiency and 132/138 in the institutions needed for growth.
A One-Way Street?
Hindsight is a cruel judge: there is little likelihood either Ecuador or El Salvador would opt for dollarization today. But it could only be reversed with trauma, given that neither economy is stable and both face widespread political discontent at home.
While Ecuador has been attempting to replace the dollar with a new-fangled cryptocurrency, the move is likely to increase investor uncertainty and hasten economic deterioration. At this point, I would argue that Ecuador and El Salvador would be wise to stop the search for magic bullets and do what they should have done from the start — undertake reforms to improve market flexibility, raise productivity and improve governance in order to capture the advantages associated with dollarization. Sometimes, the only path to health is to substitute leafy greens for the empty calories of quick fixes.