The dollarziation of Argentina and Ecuador.

Hadley, Leavell ; Hart, Sara ; Claiborne, Alan 等

ABSTRACT

Many countries are repeatedly trying to find their way out of economic or currency problems. Several of these countries have turned to the United States' dollar as a means of doing so. The U.S. dollar is a medium of exchange used throughout the world that has proven to be a strong and stable currency. This paper focuses on the implementation of dollarization for the countries of Ecuador and Argentina. It starts with defining dollarization, and reviewing the main types of dollarization. It then gives an overview of each country prior to its implementing dollarization, and next analyzes each country as a result of dollarizing. Finally, it looks at the economic prospects for the countries.

INTRODUCTION

Over the last few centuries, many countries have experiences economic disasters. Economists and governments both have debated for years over the different exchange rate regimes and how they can help an emerging or ailing economy prosper. They have theorized about a variety of monetary policies to help control inflation and initiate growth in their economies. Two countries that have recently undergone changes to turn their ailing economies around are Ecuador and Argentina.

Argentina and Ecuador have had tremendous struggles over the last few years, and had no choice but to drastically change the way their economies were managed. Both countries have resorted to a type of dollarization to try to improve the economic conditions. Dollarization, briefly summarized, is a process by which a country abandons its own currency and adopts the currency of a more stable country, commonly the United States' dollar. There are two main types of dollarization to consider: full dollarization and unofficial dollarization (Caplen, 1999).

The term full dollarization means the total elimination of a country's currency, and its complete replacement with some form of a stronger currency. Full dollarization occurs when a government makes the official decision to use a foreign currency for all transactions including government and private debt, and both public and private bank accounts are converted to dollars. The country's monetary base is converted into a dollar-denominated currency, or U.S. Federal Reserve notes. In the process of full dollarization there is a lengthy time span of conversion into the new currency. There is usually a deadline established where all holders of the domestic currency have to convert all of their domestic currency into the new currency at a predetermined rate of exchange. After the designated deadline, the previous domestic currency becomes worthless. The U.S. dollar would then be their sole legal tender (Caplen, 1999).

The more popular type of dollarization is unofficial dollarization. It is also referred to as "currency substitution." Unofficial dollarization may occur when the value of the local currency becomes too volatile. Holders of the domestic currency look for a more stable currency, and begin to use it for purchases, personal savings, and loans. When using unofficial dollarization, both currencies exist throughout the economy. People do their transactions in either currency, and most businesses throughout the economy will accept either currency (Maroney, 2002).

Countries have been using dollarization to stimulate their economy throughout the last century, but only recently has it become such a growing trend. Many citizens of countries that are plagued with high inflation or the devaluation of their currency start to look for a more stable currency to use. This process of finding and using a more stable currency is the beginning of unofficial dollarization. Once they start using this stronger, more stable currency they lose faith in their domestic currency which in turn devalues the domestic currency even more. This devaluation along with the new surplus of a strong stable currency are two strong factors which lead a country into the implementation of full dollarization (Maroney, 2002).

The purpose of this paper is to discuss the dollarization of Argentina and Ecuador. Each section begins with an overview of the country prior to its implementing dollarization. Next, the paper analyzes each country and the effects from dollarizing. The paper then concludes with prospects for, and comments about, each country's action.

LITERATURE REVIEW

Cooper and Kempf (2001) focused on a study of political institutions on inflation, and the dollarization of Argentina. Much of their study involved how dollarization can solve the inflation problem of an ailing economy. They believed that the delegation of the monetary control could reduce inflation.

Velde and Veracierto (2000) focused on the efforts of Argentina to peg its currency to the American dollar. They reviewed Argentina's history and many different types of dollarization. They analyzed the role of the lender of last resort. They ended with a cost-benefit analysis on whether Argentina should implement dollarization.

The Economist (No Good Options, 2002), published an article detailing the economic malaise in Argentina. It focused on different options that Argentina's government might use. It discussed how pegging Argentina's currency to the dollar affected its commerce, and also went over various plans to improve economic conditions, which included the devaluation of the peso.

Harper, et al (2002) wrote a study that focused on conversion currencies in the United States dollars for international trade. They thoroughly reviewed the cause of the conversions, and analyzed the results of the conversion of Ecuador due to dollarization. The study delved heavily into Ecuadorian trade in the United States.

Another study (Mixed Blessings, 2002), in Economist reported financial conditions in Ecuador after the adoption of the U.S. dollar. This study showed how inflation slowed after the implementation of a dollarization system. It also presented the concerns that Ecuador might suffer the same difficulties that Argentina experienced after they pegged their currency to the U.S. dollar.

ARGENTINA

Pre-dollarization

At the start of the twentieth century, Argentina was reportedly one of the 15 wealthiest countries in the world. They had a reported gross domestic product (GDP) per capita of only 40 percent lower than that of the United States, the world leader at that time (Velde and Veracierto, 2000). However, this early success of the country did not last.

Over the last four decades Argentina has been plagued with a very high average annual rate of inflation. Between the years of 1963-1970 the annual rate of inflation averaged 30.3 percent, then rose up to 200 percent between the years of 1973-1978. It increased to an average of 380 percent during the years of 1983-1987. By the year 1989, inflation in Argentina exceeded 3,000 percent while its markets practically ceased to function and productivity declined (Cooper and Kempf, 2001). This long history of disastrous monetary policies and repeated hyperinflations are major factors that practically forced Argentina to make the decision to change its exchange rate regime (Velde and Veracierto, 2000).

Carlos Menem was elected president of Argentina in May 1989, at a time of 78 percent monthly inflation. Over the past decade, when there has been a strong decline in an emerging market economy, the recent trend seemed to be for the ailing government to look toward some type of dollarization to solve their problems. Argentina in desperation followed this trend to help pull its country out of its turmoil (Argentina in a fix, 2001). The Argentine Congress passed the "Convertibility Law" in March 1991. This established the convertibility of the austral, the Argentine currency since 1985, into the U.S. dollar at a rate of 10,000 australes per dollar. In 1992 the peso replaced the austral, at a rate of 1 peso for 10,000 australes. Thus began Argentina's unofficial dollarization implementation (Velde and Veracierto, 2000).

Post dollarization

The laws instituted by the Convertibility Act placed strict limits on the Argentine Central Bank's policy. Under the Convertibility Law, every peso in the economy had to be backed by a dollar in reserves, and the Central Bank had to sell dollars for pesos at a rate of one U.S. dollar for one Argentine peso. It was mandated that free reserves consisting of gold and foreign currency were to be maintained at a level of no less than 100 percent of the monetary base (Velde and Veracierto, 2000).

Throughout the 1990's Argentina was known as an emerging market success story. Its success was mainly attributed to the adoption of the Convertibility Law. For the first time in many years inflation was controlled and for most of the 1990's interest rates were lower than for other similar economies. In 1995 inflation finally fell to an annual rate of less than 5 percent. In 1999, Argentina experienced a new concept of deflation as prices fell by -2.2 percent (Cooper and Kempf, 2001). This deflation was attributed to the new currency board and the adoption of the Convertibility Law.

The prosperity Argentinia experienced decades before seemed to be returning in the early 1990's, but toward the end of the decade it quickly started to disappear again. Argentina's economy simply collapsed. Brazil's currency devaluation in January 1999 appeared to be dragging

Argentina's economy down also. The unemployment rate skyrocketed to nearly 17 percent, which seemed to crush an already depressed labor force. The country that had enjoyed emerging-market status switched back to underachiever status (Pastor and Wise, 2001).

Argentina's use of unofficial dollarization was blamed for pushing the country back into recession by permitting the strong dollar to escalate the peso to damaging heights. This seemed to overvalue the currency considering similar economies have sunk as much as 40 percent compared to the U.S. dollar, throughout the same time span (Argentina in a fix, 2001). Argentina was then at a disadvantage in exchange rates making it difficult to compete in the global market, which also resulted in a widening trade deficit that was very expensive to finance (Argentina's bottomless pit, 2002) .

Another disadvantage of an unofficial dollarized economy like Argentina is that assets denominated in domestic currency begin to lose their reserve value. As uncertainty grows, so does the demand for foreign currency or for assets denominated in foreign currency. An increasing demand for foreign currency can lead to further pressure for the devaluation of the country's exchange rate. That tends to reinforce inflation, which the country is trying to avoid. When there is an increase in the number of dollar-indexed contracts, it creates levels of vulnerability of exchange rates and typically leads to a high inflation and economic instability (Studart, 2001).

Argentina's economy became highly vulnerable to the changes of expectations of future exchange rates. Changes of expectations motivated many people to withdraw huge amounts of money from the country. This reduced the international reserves, and in turn resulted in even greater financial instability of the currency (Studart, 2001). Another disadvantage countries have when they have dollarized is the inability of their Central Bank to act as the lender of last resort if their banking industry experiences a crisis. In a non-dollarized economy, the central bank can freely print currency and lend cash to the banking sector. The banks can repay these loans back to the central bank after the crisis passes. In a dollarized economy, a central bank cannot freely print the dollarized currency, which limits the lending resources (Altig and Humpage, 1999). Argentina foresaw these problems when implementing its new monetary reforms, and opted to have some control for discretionary policies. For example the Central Bank was allowed to hold up to one-third of its reserves in dollar-denominated Argentine government bonds, but it may not increase the bond holdings by more than 10 percent over the previous year's average. This allows the Argentine Central Bank to still utilize their government to alter the monetary base (Altig and Humpage, 1999).

In 1996, Argentina established the Contingent Repurchase Facility. This facility offered temporary funds to banks. The Facility gave Argentina the option to sell bonds to a group of international banks under a predetermined repurchase agreement. This established a type of lender of last resort for illiquid banks (Altig and Humpage, 1999).

There is no clear-cut pain-free solution for repairing Argentina's economy. Analysts cannot agree as to what exactly went wrong in the first place. Many analysts still advocate full dollarization as the answer to Argentina's myriad problems. This appears confusing to many others who believe that the unofficial dollarization is what brought the economy to ruins (Argentina's bottomless pit, 2002).

When Argentina's newest president, Eduardo Duhalde, arrived in office the economic options of the government seemed very limited. The past convertibility system had to come to an end. The only two logical exit options for Argentina were the freely floating peso and full dollarization (No good options, 2002).

Argentina's population did not believe that the freely floating peso would be feasible. The citizens were in favor of the devaluation of the peso, and then repegging the peso to a combination of currencies that included the euro, dollar, and Brazil's re a l (No good options, 2002). If the United States dollar grew in strength relative to Argentina's currency, it would create inflation and imbalance for the economy. Using three currencies would diminish the influence of the pegged currency.

A number of international observers agreed that a floating currency was the best turnaround option for the ailing economy. The general opinion was this would allow the peso price to fall while being controlled by the market. They argued that it would initiate a more competitive exchange rate, which could propel Argentina out of recession while providing a buffer from other external economies. However, these positives were overridden by the potential risks and costs for Argentina. One risk was that the currency could depreciate too much causing uncontrollable hyperinflation. The costs of floating a currency could be bankruptcy for many investors, firms, and banks since most debts are still in dollars, while incomes are received in pesos. With Argentina's past cycles of inflation, and their lack of confidence in the economy, these factors could have exacerbated a bad situation (No good options, 2002).

Back to a float

On January 11, 2002 Argentina ended its eleven-year peg to the U.S. dollar. After four years of recession, President Eduardo Duhalde allowed the peso to freely float, thus letting the market control the value. On the first day of the free float, the peso lost 39 percent of its value. This was not regarded as disastrous; many economists had anticipated an even larger devaluation. They suggested that the devaluation was kept down to 39 percent by the simple fact that most Argentineans had such a limited amount of cash on hand. Many wanted to purchases dollars but could not due to their lack of ready cash (Value of Argentina peso, 2002).

One way the government tried to lighten the impact of the monetary change and forecasted devaluation was to automatically convert all bank loans of $100,000 and less, on a one-to-one conversion. Another governmental maneuver was accomplished one day prior to the official float. President Duhalde ordered that all checking accounts over $10,000 and all savings accounts over $3,000 be converted into fixed term deposits, which froze them for at least one year (Value of Argentina peso, 2002).

Throughout 2002, the peso continued to decline, losing 70 percent of its value. The real GDP rose .9 percent between the first and second quarter, which was the first rise between quarters in two years. However, even with the rise, the real GDP for the year was still down 13.6 percent from the year before. The plunging value of the peso and the stringent limits on bank withdrawals directly impacted consumer spending, almost destroyed consumer credit, and pushed consumer confidence to an all-time low (Cooper and Madigan, 2002).

The Argentinean Government released a confident budget proposal for 2003. The proposal assumes 3 percent economic growth, falling inflation, and a stable peso. Many economists hail this as an optimistic fantasy, especially since the Argentina government has lost funding from the International Monetary Fund (IMF) after failing to meet the IMF's budget goals. Their first step must be to regain the IMF aid (Cooper and Madigan, 2002).

Argentina is pinning its hopes on its new monetary policy. However, with continued financial crises, government turmoil, and social unrest, 2003 is projected by most economists to be another rough year for Argentina (Value of Argentina peso, 2002).

ECUADOR

Pre-dollarization

Before the dollarization, Ecuador's economic numbers were poor and its economy was very susceptible to external shocks. In 1999, there were high levels of capital flight and internal imbalances that could have led to the collapse of the economy. The economy was drastically hurt by bank failures, a large public sector deficit, and an expansionary monetary policy. The real GDP fell by 7.3 percent in 1999, inflation hit a high of 52 percent, while the sucre depreciated by 274 percent against the dollar. The country fell into a deep recession. Declining oil prices, El Nino, and the devaluation of Brazil's currency led the Ecuadorian government to search for a way to stabilize its economy (Gajewski, 2001).

Ecuador, throughout its history, has experimented with different exchange systems. In just the last fifteen years, Ecuador has tried crawling pegs, free and controlled exchange rates, and fixed exchange rate systems. (Emanuel, 2002). Nothing worked. Politically, Ecuador continued to face repeated hyperinflation and had four presidents in as many years. The financial system collapse forced the country to default on $6 billion dollars in bonds. Another major problem was their failure to reach an agreement with the IMF. Many Ecuadorian banks perished, and the country was overwhelmed with inflation of up to 30 percent per month. The government decided to implement full dollarization as the financial solution to restore the economy (Smith, 2002).

Post-dollarization

President Jamil Mahuad, on January 9th 2000, announced that the sucre would be replaced by the U.S. dollar. He was overthrown just two weeks later. Vice President Gustavo Noboa immediately stepped in as the president and, perhaps surprisingly, continued to advocate the full dollarization proposal.

Dollarization was chosen by Ecuador to introduce a strong, stable currency into its economy (Emanuel, 2002). Under the conversion the sucre, Ecuador's national currency, was replaced at the rate of one dollar for every 25,000 sucres. The economy seemed to have recovered almost instantly (Ecuador's Political Organization, 2002).

The process of Ecuador dollarizing was divided into three parts. The first part was the unofficial dollarization process. In this process people voluntarily replaced all of their currency holdings from sucres to dollars. This started in 1990 when 99.9 percent of deposits were in sucres. The next part was that the government announced to formally dollarize. Formal dollarization occurred in January, 2000, and, because of unofficial dollarization, the economy was already 60 percent dollarized. The last segment of the process was the actual exchange of all remaining sucres for dollars in December of 2000. By this time the economy was already 97.4 percent dollarized (Emanuel, 2002).

Since the implementation of full dollarization, Ecuador's economic indicators have been rising. The confidence of investors and the public grew while interest rates dropped. It appears that dollarization in Ecuador has been a positive turning point, but it will not solve all of its problems; it is only the first step. The government will have to implement many institutional reforms and strict fiscal policies to pull the economy out of its recession. Although there are still a lot of problems in

Ecuador, dollarization appears to have tamed its hyperinflation (Gajewski, 2001). Ecuadorian Foreign Minister Heinz Moeller has declared the policy of dollarization a success. He attributes this to the strict implementation guidelines which have in effect disciplined the government's expenditures. Since it can no longer just print more currency to overcome a crisis, they in fact have averted crises (Ecuadorian Minister says, 2002).

Through the year 2000, prices started to stabilize and the measure of confidence throughout the business sector returned. Businesses reported increasing sales and hiring, and local banks reported an increase in deposits. These were positive indicators that the dollarization plan was working (Harper, et al, 2002).

Dollarization in Ecuador also helped improve tax collections. Tax collection increased from $1,300 million in 1999 to $2,300 million in 2001 giving the government much needed strength. The increase in tax collection was credited to three things: (1) the new currency was not constantly losing its purchasing power like the old currency; (2) the strengthening economy was reflected in GDP growth and tax collection; (3) the government had improved its tax collection ability through a better control of tax evasions (Emanuel, 2002).

In 2001, the Ecuadorian economy grew by 5.4 percent; the construction sector grew nearly 20 percent, retail commerce and tourism 7.7 percent, and industry by 5.5 percent. These were the fastest growth rates in Latin America (Smith 2002). Inflation in Ecuador dropped from 91 percent in 2000 to 22 percent in 2001, and the government finally seemed to have balanced the nation's budget. With the economy having shrunk by nearly 8 percent just a few years before, the economy has plenty of room to grow (Mixed Blessings, 2002). Dollarization also facilitates international exchanges. One prior drawback was that previously companies had to develop new accounting software with duplicate fields for the unofficially used U.S. dollar and their own currency. Accounting software had to take into account entries for two currencies with one field for the U.S. currency and one field for the local currency. Another example is the past retail value of many high priced products that were stated in U.S. dollars, while wages were paid in sucres. These differences made the products unaffordable for many of the Ecuadorians (Harper, et al, 2002).

Many companies throughout Ecuador were also having problems due to the volatile domestic currency. These companies began to advertise their products in U.S. dollars even before official dollarization. The companies not selling their products in the U.S. dollar were forced to require a minimum 50 percent down payment when the order was placed. This was to prevent a potential loss in profits from the volatile exchange rate. If the product was not sold within hours, the volatility of the exchange rate gouged the retailer for a loss (Harper, et al, 2002).

Since Ecuador and the United States began sharing a common currency, the value of the Ecuadorian exports to the United States rose from $250 million to $647 million. This occurred in less than two years. Also the value of U.S. exports to Ecuador decreased from $1,684 million to $1,039 million. This was an added plus for the strengthening of the economy for Ecuador, but the Ecuadorian government is still asking for special tax reductions form the U.S. on its exports to improve the trade deficit even more (Harper, et al, 2002).

Perhaps the greatest achievement of dollarization is the reduction of inflation. The average rate of inflation fell from 60 percent in 2000 to 16 percent in 2002, and is expected to soon reach single digit numbers. There has also been a strong increase in the purchasing power of its currency, and a large increase in banking deposits, indicating the growing confidence of the population. Recently, the IMF, for the first time in eighteen years, recognized Ecuador's achievements and has approved a disbursement of funds to aid the country (Emanuel, 2002).

Even with all these improvements in Ecuador's economy, many of the citizens are still not reaping the benefits. The real wages are declining, and 56 percent of Ecuadorians earned less than $42 dollars per month, which is considered poor even by Ecuadorian standards. A recent opinion poll in Ecuador focused on the two cities of Quito and Guayaquil. It revealed that half the respondents wanted to return to their former currency, the sucre (Mixed Blessings, 2002).

Ecuadorians that want to return to the sucre have many concerns about the new exchange rate system. A primary worry is the government debt. Debt services on past loans take up half of the government's budget, and any fluctuation in the government revenues could cause a default on more government loans. Also, the government's revenues are very volatile as a result of being dependent on changing oil prices. The economy has very little diversification outside of the oil industry. The last concern deals with competitiveness. With a currency growing stronger compared to similar countries, exporters are having trouble competing in markets (Mixed Blessings, 2002).

While inflation decreased, and bank deposits were on a strong increase, Ecuadorians were finding money in their pockets. They were starting to snap up imports that they could never have afforded in the past. But along with their cheaper imports, their stronger currency made exports more costly and therefore, less competitive. Also tourism sharply declined due in part to cheaper vacation prices for countries with weaker currencies (Kraul, 2002).

The effect of dollarization on Ecuador's exports and imports created a major problem of a widening trade deficit. This trade deficit is similar to what the country of Argentina went through before their economy crashed. This has many economists fearing the same situation could happen in Ecuador. (Kraul, 2002).

The ten-year old Andean Trade Preference Act expired in May, 2001. It was enacted to motivate farmers in Peru, Ecuador, Bolivia, and Columbia to not process raw cocaine. The Act helped introduce export industries to Ecuador and created a $250 million flower market (Kraul, 2002).

Ecuador has been leaning on the United States to renew the expired Andean Trade Preference Act, which would once again extend preferential trade to Andean countries. The inflation and exchange rate changes have decreased the competitiveness of Ecuadorian exports. The proposed Andean Trade Preference Act would eliminate the U.S. duties on Ecuadorian goods giving Ecuador a much better chance to compete in the U.S. market and further reducing the trade deficit (Kraul, 2002).

DISCUSSION

Since Argentina had operated a Currency Board, full dollarization would not have been as drastic a change as for most economies. The benefits and the costs of full dollarization would have been limited relative to a nation under a floating exchange rate regime. Nevertheless, a move to full dollarization would have been a large commitment. Argentina would have had to give up complete control of their money supply, along with enforcing strict policies of spending throughout all parts of their budget in government. That said, the move might have been the best choice for Argentina, precisely because it would have left the government less opportunities to destroy their economy with bad decisions (Antinolfi and Keister, 2001).

Argentina, with its new exchange rate regime, has issues that it must overcome before its economy will escape from its recession. These include: restraining inflation, restoring macroeconomic stability, and putting the economy on a path of recovery. The IMF believes to do these there needs to be a credible monetary anchor that gives the authorities the clear capacity to limit the creation of peso liquidity to the demand to hold pesos. The IMF also emphasizes that there cannot be adequate monetary control without an early and permanent solution to the problem of the release of frozen deposits. (Kohler, 2002).

In Ecuador, the government lost the capacity to control its money supply and the sucre lost much of its purchasing power value. The government moved to a full dollarization system that seems to be working, but dollarization has made prices of everyday products unstable and high. Once a price level parity is reached and prices stabilize, the strong possibility of economic growth exists. Even so, the government must reduce the outstanding government debt (Smith, 2002). There also needs to be a significant strengthening of the business industry for its economy to grow; Ecuador must be able to cope with external financial shocks of other countries. There is still much work that remains to be done to achieve a strong banking system, create complementary monetary and fiscal institutions, and reach political consensus. If all these pieces fit together, the forecast for long-term success in the monetary regime is favorable (Kraul, 2002)

CONCLUSION

Many economists agree that both Argentina and Ecuador had little choice but to make a change in their monetary policies. They both had seen their economies plagued with misfortunes and disastrous fiscal policies. Neither country was having any growth or stability with their economies. There was a lot of volatility in their currencies and inflation was uncontrollable. Both of these problems had to be controlled and a foundation for growth of their economies had to be initiated. These factors led both countries to different forms of dollarization.

Argentina has been weighed down with a history of disastrous economic monetary policies. The recent attempt to allow the peso to freely float seems to push hyperinflation, which could lead them in a circle back to where they started eleven years ago. The government has to keep strict policies not allowing hyperinflation or a massive devaluation of the peso.

Ecuador has had many problems in the past government and economic systems. Its move toward dollarization has seemed to be the pivotal point in their economic turnaround. The economic indicators have recently shown improvement; there has been growth in the economy, while inflation has plummeted, and the government has started to regain control of the national budget. With continued success of the government, growth in the economy, and confidence in its population about the economy, Ecuador could emerge into a prosperous country. The success or failure of Ecuador will be studied closely by a number of other countries contemplating dollarization as their saving grace (Kraul, 2002).

Both Argentina and Ecuador chose new exchange regimes expected to enhance their economies. Dollarization was never hailed as the panacea for all problems. In theory, both countries recognize these changes will lay the foundation for long-term economic stability and growth . For success, both countries must continue to support their decisions, build confidence throughout their populations, and implement policies that will shore up their new exchange rate regime. It will not be easy for either country, but both have the possibility to overcome the obstacles and thrive.

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Leavell, Hadley, Sam Houston State University

Sara Hart, Sam Houston State University

Alan Claiborne, Sam Houston State University