Dollarization and Semi-Dollarization in Ecuador

Abstract

In January 2000 Ecuador announced that it would dollarize fully, in response to an unprecedented crisis encompassing recession, widespread bank failures, and incipient hyperinflation. The crisis had intensified since early 1998, when a combination of external and climatic shocks set it off. The economy's partial dollarization made the crisis far worse than it would otherwise have been. The move to full dollarization is perhaps best understood as a structural reform to end an unstable dual-currency system.

Over the 1980s and 1990s, GDP growth had stagnated on account of oil-export price volatility and natural disasters; the sacrifice of capital formation to heavy external public debt service; and incomplete, uneven structural reform. The exchange rate depreciation that proved continually necessary to sustain the net-export surplus and limit external debt accumulation induced Ecuadorians to dollarize spontaneously.

The 1998 shocks affected real economic activity-hence bank loan portfolios, and widened the fiscal and current account deficits. The external imbalance led to exchange rate depreciation. Dollar-denominated bank loans whose borrowers lacked dollar income increasingly turned non-performing. At the same time, the depreciation swelled the local currency value of dollar deposit liabilities. Many depositors, fearing that banks had become unsafe, withdrew, and over 1999 the Central Bank had to provide banks massive liquidity support. By year's end the resulting monetary issue led to the exchange rate collapse and incipient hyperinflation that forced the move to full dollarization.

Ecuador's Central Bank will continue operating, using its foreign exchange holdings to carry out limited liquidity management and lender-of-last-resort activities. Ecuador's public accounts and banking system remain vulnerable to commodity-price and natural shocks. Exchange rate adjustment and monetary expansion are no longer available, however, to manage the external accounts, accommodate the public deficit, or assist failing banks. Further structural reform remains essential to assure fiscal discipline and banking system safety.

This paper - a product of the Economic Policy Sector Unit, Latin America and the Caribbean Region - is part of a larger effort in the region to understand the sources of macroeconomic instability and the implications of currency board arrangements and dollarization.