“What exactly is dollarization?”
Dollarization is the process of aligning a country's currency with the US dollar. Dollarization can occur unofficially, without formal legal approval, or officially, when a country ceases to issue a domestic currency and uses only the US dollar. The first country to undergo dollarization was Panama in 1904, as part of its Constitution. Similarly, because of economic instability, Ecuador underwent stages of unofficial and then official dollarization. Through this process, Ecuadorian sucre were officially replaced by US dollars at a rate of 25,000 to 1. As follows, through a series of informal questions and answers, the reasons, benefits, and setbacks of and for dollarization will be investigated.
“Why the US dollar?”
In Ecuador, the US dollar was the choice currency to switch to for several reasons. One of them is that the US stands to be Ecuador’s largest trading partner. By dollarizing, the cost of trade with the US is decreased and therefore long-term investment can be promoted. Another reason in favor of switching to the US dollar was simply that Ecuador followed Panama’s example, a country that had already dollarized and was not facing severe inflation like Ecuador at the time. To obtain US dollars, Ecuador had to run a surplus in their international trade by selling more commodities such as oil, chocolate, and bananas in order to obtain dollars and gain liquidity. Countries that use the US dollar as a legal currency include: Panama, Ecuador, East Timor, El Salvador, Marshall Islands, Micronesia, Palau, Turks and Caicos, British Virgin Islands, and Zimbabwe.
“What was happening in Ecuador at the time of dollarization?”
In the late 1990s, Ecuador was facing currency instability. A combination of low tax base for the non-oil sector, low oil prices, and big public sector wage increases created a severe economic crisis. At the beginning of 1997, one dollar was worth 4,000 sucres. By 1999, that number increased to 25,000 sucres per dollar. Inflation is the increase in prices that takes place when there is too much money to spend, while the products and services available stay the same. Around 2000, Ecuador was facing high inflation rates of 104%, well beyond the 3% rate that is considered concerning in the American economy. The Ecuadorian central bank was printing too much money to make up for decades of deficit spending, creating bursts of inflation in the economy. The major issue was that inflation was a recurring event. Ecuadorian officials were looking to draw investment back into the country and create jobs to boost the economy by restoring the credibility of Ecuador’s financial system. Dollarization was designed to prevent the government from printing money excessively because now the money had to be shipped in from the US to Ecuador instead. In January 2000, then President Jamil Mahuad announced that Ecuador would adopt the US dollar as legal tender. Mahuad was soon ousted and replaced by his vice president who went through with the plan. Similarly, in 2001, El Salvador followed Ecuador and also dollarized. (*)
“Did dollarization work?”
As a result of dollarization, Ecuador has seen improvements in banking performance, competitiveness, and transparency. It has enabled Ecuador to modernize and improve banking regulations and provide a safer banking system. Dollarization has improved bank liquidity and asset quality. The stability of the exchange rate has promoted long-term investment and trade. Traded sectors such as finance, transportation, communication, tourism and hospitality, and the county’s significant oil industry have all benefited from the ease of foreign transactions and high investment. Subsequently, inflation has been low. Currently, Ecuador’s inflation rate is expected to stand at 1.20% in 12 months’ time.
“Will Ecuador ever stop using the dollar?”
Dollarization comes with its set of problems, primarily sacrificing a country’s ability to manage its own economy, especially in times of need, because of its reliance on a foreign power. Additionally, while traded sectors benefited, local sectors and the traditional village economy have not. A major issue with dollarization is the exchange rate that creates fractional amounts of change and therefore a need for coins that are more expensive to ship in than dollars. Merchants would round prices to the dollar, which is a problem when two-thirds of Ecuadorian workers earn less than $30 dollars a month. Merchants had trouble attracting customers because they could not produce change and were forced to continue taking sucres. In response, Ecuador has followed Panama’s example of using US bills but minting its own form of the coins, creating a mixed currency. However, this has only been implemented in bigger cities. Availability of coin currency is still low in smaller Ecuadorian cities. Given the many issues and benefits that dollarization involves, economists find it difficult to predict whether the move will prove sustainable in the long term. Economists are saying, however, that dollarization must be backed by reforms that guarantee a smooth flow of dollars into the country.
“What happened to the sucre?”
The sucre has become obsolete and it is now treated as a potential souvenir for tourists. While most Ecuadorians are not exactly begging for the return of the sucre as a form of currency, there is a sense of loss of national identity. By replacing Ecuadorian national heroes for green George Washingtons, Ecuador sacrificed its historical currency in exchange for a distinctly American currency.
“What’s happening now?”
In 2008, then President Rafael Correa began to limit the transparency of the banking system. At the same time, money that should have been used to back dollarization was instead used to finance public spending. Dollarization became backed by government bonds, a non-liquid asset. Overtime, Ecuador’s debt level grew, doubling since 2010 to reach $32 billion in 2015. In the same year, Ecuador started using digital currency which is designed to support its dollar-based monetary system, rather than replace it. A digital currency would, in theory, allow Ecuador's central bank to issue new money that is not directly tied to its U.S. dollar reserves.
“Is Ecuador’s digital currency like Bitcoin?”
Ecuador’s digital currency is not that similar to the Bitcoin. The latter is a digital token running on a decentralized electronic network, while Ecuador’s electronic money system is controlled by the government, being directly tied to the dollar. In many ways, it is a government-run version of Venmo. While some argue that this is the first step towards de-dollarization, others say that this project will support dollarization instead of overhauling it.