Description
Dollarization taking the example of Ecuador and Panama.It initally starts off with the leading factors for dollarization in these countries and the solution for the same.
Dollarization
Ecuador & Panama
ECUADOR
Leading Factors
Early 1970s: discovery of Oil reserves Subsequent Benefits from Oil exports
1980’s- Oil Markets Crashed
Debt > Growth of Oil exports Debt –20% in 1973 to 118 % of GDP in 1988
Collapses in other South American economies such as Brazil sent Ecuador’s economy into a tailspin • the sucre fell into hyperinflation • the country defaulted on its foreign debt • entire banking sector collapsed as Ecuadorians rushed to put their accounts into a more stable currency, such as the US dollar. This impromptu wave was called ‘semi-dollarization’
1997 – 1998
El Niño Oil Prices- new low
- The first bank, Filanbanco, was bailed out by the Central Bank - The war against the sucre began. Central Bank tried to maintain the value of the sucre by selling dollars , which reduced its foreign reserves. Increased mistrust in society against banking system
- Central Bank declared the free flow of the sucre. The exchange rate sucre-dollars doubled in a few days. - Other banks went bankrupt, the regime froze accounts of the public to prevent run on reserves of banks, and the value of sucre from decreasing even further
- Although the accounts were "frozen", the banks still were in serious
solvency problems, because the indebted found themselves with less capacity to pay their debts. - Central Bank increased the interest rates in order to prevent the devaluation of the sucre. This made the debts even more unpayable - Those indebted in sucres could not pay their credits anymore due to the high interest rates. Those indebted in dollars found themselves in serious jeopardy, because the devaluation made their payments go up and their income did not rise in the same manner.
- The size of the "pie" (GDP) reduced from 20 billion dollars to 14 billion dollars in 1999 - This led to more unemployment and a significant loss of acquisition power. - The economy drowned due to the lack of capital and more Ecuadorians sent their money to off shore accounts.
- The government found itself in a dead end, in spite of the fact that the price of petroleum increased considerably. - The regime announced that it was no longer capable of paying the Brady Bonds ,which was the finishing hit to international trust.
- The transition between 1999 and 2000 determined an out of control devaluation. - The exchange rate, sucres-dollars, increased from 16,000 sucres to 20,000 sucres in just a few weeks, and then from 20,000 sucres to 26,000 in a few days. - The inflation went up to approx. 100% annually.
The regime was at a point of no return, as the negotiations with the IMF continued to be stuck
- Because of the default on the Brady bonds, Ecuador could no longer renegotiate and restructure portions of its debt and lost access to any other capital flows. - This led President Mahuad to make his desperate dollarization declaration. He had dismissed dollarization only days before.
The Solution
• Small economies in a period of free capital movements faced daunting
tasks in attaining exchange rate stability (exchange rate instability has been
endemic in Latin America and Ecuador since the 1970s) , mainly because they were unable to maintain credibility in their exchange rate policy. Also, there were fundamental inconsistencies in their external policy (fixed exchange rates) and internal policy (expansionary monetary policy to service debts, inflation) • This led to the “bi-polar view” (Fischer 2001) that such countries had only two choices, to float their currencies or to adopt a “hard-peg.” Dollarization is the extreme hard peg
What is Dollarization
A monetary system in which a country renounces its own currency and adopts a foreign currency to use as a legal tender.
Unofficial Dollarization
Unofficially, when private agents prefer the foreign currency over the domestic currency
Semi official Dollarization
Where foreign currency is a legal tender, but plays a secondary role to domestic currency
Official Dollarization
• Officially, when a country ceases to issue the domestic currency and uses only foreign currency. • It adopts the foreign currency as legal tender
The economics behind the decision
Our analysis on the decision of Ecuador being strictly dollarized relies on two strands of literature • The optimum currency areas literature pioneered by
Mundell (1961), and
• The political economy of exchange rates and currency
regimes
Optimum Currency Area
Criteria
• Small size and openness of economy • Geographical proximity • Considerable trade with the issuing country • An economy in which the to-be-adopted currency is widely used • Need to import monetary stability due to a history of hyperinflation
Comparing Ecuador and the US
Ecuador Area (sq km) 283,560 USA 9,629,091
Population
GDP (2000) GDP per capita (2000) Currency
13 million
$37.2 billion (PPP) $2900 (PPP) Sucre (before) USD (after)
280 million
$9.96 trillion (PPP) $36,200 (PPP) USD
?Small size and openness of economy ?Geographical proximity
Trade Relations
The US is Ecuador’s main trade partner:
• The US is the country to which
Ecuador exports the most. • The US is the country from which Ecuador imports the most.
Other major trade partner:
Andean Community, specially
Colombia
Currency parameters
• Most of the important transactions are conducted in the foreign currency • People prefer to save in the foreign currency, because they feel that it will not lose its value rapidly
•
Before the year 2000, Ecuador was in
fact an unofficially dollarized country (more than 40% of Ecuador’s broad money currency) was deposits in foreign
Extremely high rate of inflation
Political Economy of Exchange rates
• Total external debt • Exchange rates
• Budget Deficit
Exchange rates:
The most important price in any economy, for it affects all other prices
Impact of dollarization
1997 Per Capita GDP Growth Imports
Expenditure
1998 0.4
1999 -7.3
2000 2.3
2001 4.6
3.4
8.8 2.0 4.0
5.5 1.8 6.3
-39.0 -10.4 -35.5
18.7 1.8 10.5
25.9 2.6 30.5
Gross Capital Formation Exports
4.3
-3.2
-0.4
-0.2
7.8
Source: Central Bank of Ecuador
Inflation
Real GDP Growth Rate
The Good
Dollarization as a factor of stability, restoration of confidence in the Banking system Decrease in Nominal Interest Rates from 200% to 16% - Reduced the cost of international credit (by eliminating the the risk of currency devaluation, gains lower interest rates on foreign borrowing)
The Bad
Appreciation of the real exchange rate after dollarization for almost 2 years (due to still high inflation rate) - Exports becoming uncompetitive (Ecuador, we may note, has been comparatively lucky, since it dollarized in a period that the dollar has lost around 30% of its value against other currencies)
The Ugly
Loss of Monetary Sovereignty (to counter internal/external shocks, recession) - Internal Debt (from 607.4 million in 2000 to 1,056.8 million dollars in 2003), no fiscal discipline - A big percentage of the fiscal budget (about 40% during 2001) goes toward servicing the foreign debt at the expense of the social investment.
- Controlled Inflation to an extent (still highly governed by fluctuations in world commodity prices) Boost to FDI & FIIs, economic expectations
Mismatch between business cycles of American & Ecuadorian economies
Every price was converted to dollars, thus reduction in real wages (esp. Govt officials, retires) Unemployment (when the wage pie decreases due to external shock, interest rates increase, reduction in consumption and investment) Dollarization has failed to address the core structural issues of the Ecuadorian economy (payments of the external debt, low competitiveness, high costs of production, low productivity)
Economic performance remains highly dependent on capital inflows
Elimination of transaction costs of exchanging one currency into another (esp. in a semi-dollarized as Ecuador before 2000)
- Loss of Seigniorage - Loss of lender of last resort - Supply of money dependent on BoP
Therefore, • Dollarization , as any other monetary system, is oriented to the shortterm economic solution. • The major risk to the dollarization, particularly in Ecuador, comes precisely from the lack of short and long-term perspectives to help strengthen the macroeconomics and the governability of the country However, • Ecuador lacks a reliable political system, legal system, or investment climate • Dollarization is the only government policy that provides Ecuadorians with a trustworthy basis for earning, saving, investing, and paying • Nobody would trust a new national currency; the historical record is too bad and the institutions to support it are too politicized • Rather than promoting stability, a new national currency would instantly destabilize an already troubled economy
PANAMA
Panama
• Panama became the first fully dollarized economy in Latin America in 1904 after gaining independence from Colombia
• Although a national currency, the balboa, which notionally exists, only a negligible amount of balboa coins actually circulate in practice
• Panama’s decision to adopt full dollarization was based on political and historical considerations rather than economic ones • Fits OCA criteria • Political explanation – Americans were active in encouraging the onetime province of Colombia to break away in 1904, so that they could build the Panama canal. • Panama had been the victim not long before of a hyperinflation in Colombia’s currency- there was a desire for monetary stability
Financial Integration Government Banks
Efficient and stable financial markets
Government
• Little or no interference on its behalf
– No reserve requirements
• Cannot monetize its debt
– Two ways to avoid debt
• Loans from abroad • Increase taxes
– Leads to prudent decision making
Financial integration
• Along with dollarization leads to low rate differentials • A unified currency leads to – Elimination of foreign exchange risk – Currency mismatches – Speculative attacks (associated with devaluation) • Investments only in viable projects • No concept of excess liquidity • Leads to low inflation over a long period of time (Balassa-Samuelson effect)
Banks
• Private banks (and agents) determine stock of money • Great competition lead to safer practices
– Improved risk management systems
• • • • •
Large commercial lending became possible Lending for home mortgages became possible Freedom of entry of foreign investors No restriction on movement of capital Market determined interest rates
The 1988 Crisis
Real GDP decreased approximately 16 percent in 1988 and 0.4 percent in 1989, and there was largescale capital flight.
Most local banks were forced to close, and the economy was squeezed by a severe liquidity shortage
Major economic crisis erupted between 1987-1989 as a result of political tensions between the governments of Panama and the In 1988, a U.S. court United States indicted Manuel Noriega, Panama’s military leader, and imposed economic sanctions on Panama
Panamanian assets in U.S. banks were frozen, and all payments and dollar transfers to Panama were prohibited
Low inflation
No excess funds
Market stability
Low rate differential
Investor confidence
Full financial integration + dollarization
References
• • • • • • • • • • • • http://www.cato.org/pubs/journal/cj25n1/cj25n1-14.pdf http://www.fenixpanama.com/dollarization-of-panama.html http://www.frbatlanta.org/invoke.cfm?objectid=87B67D23-6666-11D593390020352A7A95&method=display http://www.cato.org/pubs/journal/cj25n1/cj25n1-13.pdf http://www.petersoninstitute.org/publications/chapters_preview/342/6iie3365.pdf http://www.cap.lmu.de/transatlantic/download/Cohen.PDF http://www.swlearning.com/economics/policy_debates/dollarization.html http://www.allbusiness.com/finance/4096492-1.html http://www.mindspring.com/~tbgray/dollar.htm http://www.econ.utah.edu/activities/papers/2004_05.pdf http://www.monografias.com/trabajos10/dollla/dolla.shtml http://www.appropriateeconomics.org/latin/ecuador/dollarization_in_ecuador_%20-_marconi.pdf http://www.nsi-ins.ca/english/pdf/09_delatorre.pdf http://www.ecuador.com/blog/the-greenback-goes-south-dollarization-in-ecuador
• •
Thank You
doc_678916542.pptx
Dollarization taking the example of Ecuador and Panama.It initally starts off with the leading factors for dollarization in these countries and the solution for the same.
Dollarization
Ecuador & Panama
ECUADOR
Leading Factors
Early 1970s: discovery of Oil reserves Subsequent Benefits from Oil exports
1980’s- Oil Markets Crashed
Debt > Growth of Oil exports Debt –20% in 1973 to 118 % of GDP in 1988
Collapses in other South American economies such as Brazil sent Ecuador’s economy into a tailspin • the sucre fell into hyperinflation • the country defaulted on its foreign debt • entire banking sector collapsed as Ecuadorians rushed to put their accounts into a more stable currency, such as the US dollar. This impromptu wave was called ‘semi-dollarization’
1997 – 1998
El Niño Oil Prices- new low
- The first bank, Filanbanco, was bailed out by the Central Bank - The war against the sucre began. Central Bank tried to maintain the value of the sucre by selling dollars , which reduced its foreign reserves. Increased mistrust in society against banking system
- Central Bank declared the free flow of the sucre. The exchange rate sucre-dollars doubled in a few days. - Other banks went bankrupt, the regime froze accounts of the public to prevent run on reserves of banks, and the value of sucre from decreasing even further
- Although the accounts were "frozen", the banks still were in serious
solvency problems, because the indebted found themselves with less capacity to pay their debts. - Central Bank increased the interest rates in order to prevent the devaluation of the sucre. This made the debts even more unpayable - Those indebted in sucres could not pay their credits anymore due to the high interest rates. Those indebted in dollars found themselves in serious jeopardy, because the devaluation made their payments go up and their income did not rise in the same manner.
- The size of the "pie" (GDP) reduced from 20 billion dollars to 14 billion dollars in 1999 - This led to more unemployment and a significant loss of acquisition power. - The economy drowned due to the lack of capital and more Ecuadorians sent their money to off shore accounts.
- The government found itself in a dead end, in spite of the fact that the price of petroleum increased considerably. - The regime announced that it was no longer capable of paying the Brady Bonds ,which was the finishing hit to international trust.
- The transition between 1999 and 2000 determined an out of control devaluation. - The exchange rate, sucres-dollars, increased from 16,000 sucres to 20,000 sucres in just a few weeks, and then from 20,000 sucres to 26,000 in a few days. - The inflation went up to approx. 100% annually.
The regime was at a point of no return, as the negotiations with the IMF continued to be stuck
- Because of the default on the Brady bonds, Ecuador could no longer renegotiate and restructure portions of its debt and lost access to any other capital flows. - This led President Mahuad to make his desperate dollarization declaration. He had dismissed dollarization only days before.
The Solution
• Small economies in a period of free capital movements faced daunting
tasks in attaining exchange rate stability (exchange rate instability has been
endemic in Latin America and Ecuador since the 1970s) , mainly because they were unable to maintain credibility in their exchange rate policy. Also, there were fundamental inconsistencies in their external policy (fixed exchange rates) and internal policy (expansionary monetary policy to service debts, inflation) • This led to the “bi-polar view” (Fischer 2001) that such countries had only two choices, to float their currencies or to adopt a “hard-peg.” Dollarization is the extreme hard peg
What is Dollarization
A monetary system in which a country renounces its own currency and adopts a foreign currency to use as a legal tender.
Unofficial Dollarization
Unofficially, when private agents prefer the foreign currency over the domestic currency
Semi official Dollarization
Where foreign currency is a legal tender, but plays a secondary role to domestic currency
Official Dollarization
• Officially, when a country ceases to issue the domestic currency and uses only foreign currency. • It adopts the foreign currency as legal tender
The economics behind the decision
Our analysis on the decision of Ecuador being strictly dollarized relies on two strands of literature • The optimum currency areas literature pioneered by
Mundell (1961), and
• The political economy of exchange rates and currency
regimes
Optimum Currency Area
Criteria
• Small size and openness of economy • Geographical proximity • Considerable trade with the issuing country • An economy in which the to-be-adopted currency is widely used • Need to import monetary stability due to a history of hyperinflation
Comparing Ecuador and the US
Ecuador Area (sq km) 283,560 USA 9,629,091
Population
GDP (2000) GDP per capita (2000) Currency
13 million
$37.2 billion (PPP) $2900 (PPP) Sucre (before) USD (after)
280 million
$9.96 trillion (PPP) $36,200 (PPP) USD
?Small size and openness of economy ?Geographical proximity
Trade Relations
The US is Ecuador’s main trade partner:
• The US is the country to which
Ecuador exports the most. • The US is the country from which Ecuador imports the most.
Other major trade partner:
Andean Community, specially
Colombia
Currency parameters
• Most of the important transactions are conducted in the foreign currency • People prefer to save in the foreign currency, because they feel that it will not lose its value rapidly
•
Before the year 2000, Ecuador was in
fact an unofficially dollarized country (more than 40% of Ecuador’s broad money currency) was deposits in foreign
Extremely high rate of inflation
Political Economy of Exchange rates
• Total external debt • Exchange rates
• Budget Deficit
Exchange rates:
The most important price in any economy, for it affects all other prices
Impact of dollarization
1997 Per Capita GDP Growth Imports
Expenditure
1998 0.4
1999 -7.3
2000 2.3
2001 4.6
3.4
8.8 2.0 4.0
5.5 1.8 6.3
-39.0 -10.4 -35.5
18.7 1.8 10.5
25.9 2.6 30.5
Gross Capital Formation Exports
4.3
-3.2
-0.4
-0.2
7.8
Source: Central Bank of Ecuador
Inflation
Real GDP Growth Rate
The Good
Dollarization as a factor of stability, restoration of confidence in the Banking system Decrease in Nominal Interest Rates from 200% to 16% - Reduced the cost of international credit (by eliminating the the risk of currency devaluation, gains lower interest rates on foreign borrowing)
The Bad
Appreciation of the real exchange rate after dollarization for almost 2 years (due to still high inflation rate) - Exports becoming uncompetitive (Ecuador, we may note, has been comparatively lucky, since it dollarized in a period that the dollar has lost around 30% of its value against other currencies)
The Ugly
Loss of Monetary Sovereignty (to counter internal/external shocks, recession) - Internal Debt (from 607.4 million in 2000 to 1,056.8 million dollars in 2003), no fiscal discipline - A big percentage of the fiscal budget (about 40% during 2001) goes toward servicing the foreign debt at the expense of the social investment.
- Controlled Inflation to an extent (still highly governed by fluctuations in world commodity prices) Boost to FDI & FIIs, economic expectations
Mismatch between business cycles of American & Ecuadorian economies
Every price was converted to dollars, thus reduction in real wages (esp. Govt officials, retires) Unemployment (when the wage pie decreases due to external shock, interest rates increase, reduction in consumption and investment) Dollarization has failed to address the core structural issues of the Ecuadorian economy (payments of the external debt, low competitiveness, high costs of production, low productivity)
Economic performance remains highly dependent on capital inflows
Elimination of transaction costs of exchanging one currency into another (esp. in a semi-dollarized as Ecuador before 2000)
- Loss of Seigniorage - Loss of lender of last resort - Supply of money dependent on BoP
Therefore, • Dollarization , as any other monetary system, is oriented to the shortterm economic solution. • The major risk to the dollarization, particularly in Ecuador, comes precisely from the lack of short and long-term perspectives to help strengthen the macroeconomics and the governability of the country However, • Ecuador lacks a reliable political system, legal system, or investment climate • Dollarization is the only government policy that provides Ecuadorians with a trustworthy basis for earning, saving, investing, and paying • Nobody would trust a new national currency; the historical record is too bad and the institutions to support it are too politicized • Rather than promoting stability, a new national currency would instantly destabilize an already troubled economy
PANAMA
Panama
• Panama became the first fully dollarized economy in Latin America in 1904 after gaining independence from Colombia
• Although a national currency, the balboa, which notionally exists, only a negligible amount of balboa coins actually circulate in practice
• Panama’s decision to adopt full dollarization was based on political and historical considerations rather than economic ones • Fits OCA criteria • Political explanation – Americans were active in encouraging the onetime province of Colombia to break away in 1904, so that they could build the Panama canal. • Panama had been the victim not long before of a hyperinflation in Colombia’s currency- there was a desire for monetary stability
Financial Integration Government Banks
Efficient and stable financial markets
Government
• Little or no interference on its behalf
– No reserve requirements
• Cannot monetize its debt
– Two ways to avoid debt
• Loans from abroad • Increase taxes
– Leads to prudent decision making
Financial integration
• Along with dollarization leads to low rate differentials • A unified currency leads to – Elimination of foreign exchange risk – Currency mismatches – Speculative attacks (associated with devaluation) • Investments only in viable projects • No concept of excess liquidity • Leads to low inflation over a long period of time (Balassa-Samuelson effect)
Banks
• Private banks (and agents) determine stock of money • Great competition lead to safer practices
– Improved risk management systems
• • • • •
Large commercial lending became possible Lending for home mortgages became possible Freedom of entry of foreign investors No restriction on movement of capital Market determined interest rates
The 1988 Crisis
Real GDP decreased approximately 16 percent in 1988 and 0.4 percent in 1989, and there was largescale capital flight.
Most local banks were forced to close, and the economy was squeezed by a severe liquidity shortage
Major economic crisis erupted between 1987-1989 as a result of political tensions between the governments of Panama and the In 1988, a U.S. court United States indicted Manuel Noriega, Panama’s military leader, and imposed economic sanctions on Panama
Panamanian assets in U.S. banks were frozen, and all payments and dollar transfers to Panama were prohibited
Low inflation
No excess funds
Market stability
Low rate differential
Investor confidence
Full financial integration + dollarization
References
• • • • • • • • • • • • http://www.cato.org/pubs/journal/cj25n1/cj25n1-14.pdf http://www.fenixpanama.com/dollarization-of-panama.html http://www.frbatlanta.org/invoke.cfm?objectid=87B67D23-6666-11D593390020352A7A95&method=display http://www.cato.org/pubs/journal/cj25n1/cj25n1-13.pdf http://www.petersoninstitute.org/publications/chapters_preview/342/6iie3365.pdf http://www.cap.lmu.de/transatlantic/download/Cohen.PDF http://www.swlearning.com/economics/policy_debates/dollarization.html http://www.allbusiness.com/finance/4096492-1.html http://www.mindspring.com/~tbgray/dollar.htm http://www.econ.utah.edu/activities/papers/2004_05.pdf http://www.monografias.com/trabajos10/dollla/dolla.shtml http://www.appropriateeconomics.org/latin/ecuador/dollarization_in_ecuador_%20-_marconi.pdf http://www.nsi-ins.ca/english/pdf/09_delatorre.pdf http://www.ecuador.com/blog/the-greenback-goes-south-dollarization-in-ecuador
• •
Thank You
doc_678916542.pptx