Index

1. Introduction

2. Concept of dollarization

3. Dollarization in Ecuador

4. Dollarization monetary instruments

5. Inflation

6. Two Years Later

7. Conclusions

1. Introduction

On Sunday 11 January 2000 President Jamil Mahuad announced its decision to dollarization of the Ecuadorian economy after anchoring the currency price at a level of 25,000 sucres.

“The system of dollarization is the only way we have now and is the path we must travel.” Mahuad also said that dollarization is adopted taking into account the Government’s technical studies and

other state institutions.

According Mahuad are several advantages: the dollar will remain firm and stable, allow interest rates to be located at the international level and that inflation is reduced to below 10%.

2. Concept of dollarization

Calvo and Vegh (1992) note that this refers to any process where foreign money replaces the domestic money in all its three functions. The process may have different origins:

* This can be due to the colonization of a country that happens to use the currency of the colonizer.

* Autonomous and sovereign decision of a nation that decides to use the dollar as genuine currency, being in these cases of a currency reform by the supply side.

* On the demand side is as a result of portfolio decisions of individuals and companies switching to the dollar as currency, perceiving it as a refuge from the loss of value of domestic currency in contexts of extreme price volatility and exchange rate.

It could distinguish two processes of dollarization on the demand side:

* Currency substitution

* The replacement of assets.

Informal dollarization

Has several stages: the first is the replacement of assets, the second currency substitution and the third stage, many

products and services are traded in foreign currency.

Informal dollarization has perverse consequences for the economy of a country.

* Hampers the chances of monetary authorities to stabilize the economy and control inflation, monetary policy has little effectiveness.

* Generates pressure on him and determines exchange rate policy.

* It causes deterioration of local currency denominated revenues.

* It weakens the domestic financial sector.

* Decreases precionamos seigniorage and difficult public by the inflation tax.

Official Dollarization

Involves the replacement of 100% of local currency for foreign currency, full dollarization rests on some specific principles:

* The single currency is the foreign currency and local currency disappears.

* The money goes to be denominated in dollars and feeds on the balance of the balance of payments, others in an initial amount of reserves.

* The capital is free to enter and leave without restriction.

* The Central Bank abandoned its traditional functions.

Formal advantage of dollarization

* It emphasizes the effects of external shocks.

* The inflation rate equals the local with the United States.

* It reduces the spread between domestic and international interest.

* It facilitates financial integration.

* It reduces some transaction costs.

* We produce social benefits.

* Structural problems are discovered.

* It creates fiscal discipline.

Formal cost of dollarization

* The cost of the loss of seigniorage.

* Cost of processing and general.

* Authorization of the Federal Reserve of the United States.

* The problem of external shocks.

Dollarization of Ecuador’s economy .-

The Ecuadorian economy is typically small and open with an estimated population of 12.2 million inhabitants, its GDP was close to $ 20,000 million in 1998, 1999 was a contraction of U.S. $ 13.664 million. Its GDP per capita in 1998 reached $ 1619 in 1999 was $ 1101. The production is divided by 30.7% in the primary sector, which production is for the exploitation of oil, 19.6% in the secondary sector and 49.7% in the services sector. Unemployment affects 18.2% of the economically active population (PEA), the underemployment (informal) consists of 54.4% of the PEA, and only 27.4% have a formal job.

In January 1999 the minimum wage in force (SMVV) reached 134.18 dollars, after one year equals only $ 44.

* Inflation in December 1999 of 60.7% annual

* The active domestic interest rates (30 days) of 75%.

* Exports in 1999 of 4.194 billion dollars.

* Imports in 1999 of 2.601 billion dollars.

* The external public debt in 1999 to 13.7411 billion dollars.

* The private external debt in 1999 of 2.0341 billion dollars.

Final Thoughts .-

The benefits of dollarization are:

* Removes exchange rate uncertainty.

* Eliminating exchange rate risk disappears differential between lending rates in local currency and in dollars.

* Excluding currency reserve dollars BC passed into the hands of the people.

* Removes any possible wage and price indecision of the economy.

* In the short term stability produced by the dollarization leads to increased savings of the population.

* It eliminates the chance that the CB acts as a lender of last stay away moral hazard.

Dollarization requires.

* A rigorous prudential supervision.

* A state tax dollars to be charged, expenses in dollars in dollars in debt and repay your debts in dollars.

* A Central Bank to stop giving foreign assets, becoming an institution regulation and supervision of banking and payments system and analysis of macroeconomic variables for further development.

* Waiver of discretionary measures to control capital flows.

* An acceleration of continental integration under NAFTA and the FTAA.

* An automatic system that resides on the rebalancing of portfolios of assets of all financial actors in the country.

* Legal clauses, if possible constitutional, giving to the dollarization irreversible character, otherwise it would not be credible.

3. Dollarization in Ecuador

One year later

Introduction

In recent years, the impact of adverse shocks such as the fall in oil prices and the impact of El Ni~no, was reflected in a fundamental deterioration in the economy. These facts became evident weaknesses in the financial system and deepened the fiscal deficit and were ingredients that contributed to further deterioration in key economic variables. In this context, monetary policy alone could not cope with the crisis at a time and had to be subordinated to the needs of the financial system.

Definitely, the severe economic instability demanded a comprehensive strategy aimed at restoring the credibility of macroeconomic management and provide clear signals about future performance of the economy. Discussed the various alternatives to address this critical situation, government authorities opted for dollarization scheme.

Ecuador has become one of the pioneers of dollarization.

1. The context in which it applies dollarization

Informal dollarization of the Ecuadorian economy

A broad concept of dollarization is a process that replaces the foreign currency to local currency in all its three functions: store of value, unit of account and medium of exchange or return.

The dollarization process may have different origins. One is for the supply side which means the decision of an independent and sovereign nation that decides to use the dollar as genuine currency, another possible source is the demand side, and results from the decision of individuals and businesses to use the dollar, the loss confidence in the domestic currency, in scenarios of high price volatility and exchange rate volatility. The use of the dollar stems in the latter case, the preventive behavior of individuals rationally choose to preserve the value of keeping their wealth in dollars and shelter and the devastating impact of devaluations and high inflation. Among the factors that explain the phenomenon of informal dollarization, especially in Latin American countries is macroeconomic instability, persistent fiscal deficits, underdeveloped financial markets, lack of credibility in stabilization programs, the economic globalization, the history of high inflation, institutional factors, among others. In Ecuador, the dollarization first responded to a spontaneous process, which aimed to prevent deterioration in the purchasing power of local currency. Informal dollarization process has several stages: the first, known as asset substitution, the agents acquire foreign bonds or deposit a certain amount of their savings in foreign currency in the second, called currency substitution, the agents acquire means of payment foreign currency, dollar notes and open bank accounts in dollars, and finally, the third stage, many goods and services quoted and paid in dollars.

At the gates of dollarization: economic indicators

Following the financial crisis and fiscal 1999, the Central Bank of Ecuador, on several occasions, discussed the need to adopt comprehensive measures in monetary, exchange and financial, to avoid an escalation hyperinflationary as the solution applied to imbalances banking and currency mismatch variables reduces the effectiveness of traditional policy measures.

Due to the legal form of solution to be adopted to tackle the financial crisis, monetary management by the Central Bank was subject to financial targets. This situation had repercussions on an accelerated growth of the monetary issue, producing uncontrollable pressures on the exchange rate and weakening the policy interest rates to counter rising currency depreciation. It should be noted that the annual variation of the exchange rate reached 195% over 1999. Additionally, during the first days of January 2000 continued the upward climb of the contribution to such an extent that, after January, the depreciation was 25% compared to December 1999.

Interest Rate and Exchange Rate

For his part, as a tool of monetary policy, and intended to offset the exchange performance, the Central Bank of Ecuador, the interest rate used as an active tool to reduce agents’ expectations, with the panorama of uncertainty revealed by the preference to invest in dollars.

In this context, the level of interest rates was increasing. The interbank rate was at 152% in late December 1999, with the consequent impact on the benchmark lending and deposit rates, which reached 75% and 48% respectively.

Additionally, through desagio was determined by a one-time adjustment of lending rates and deposit all obligations, applying rates of 16.82% and 9.35% respectively. You agree prohibits obligations involving indexing, restatement or any other form of re-powering of the debts, as the indexation of wages or salaries.

Law for Promotion of Investment and Citizen Participation

The main focus reforms contained in the following legislation: the State Modernization Law, the Hydrocarbons Law, Mining Law, Law on the Electricity Industry Act Monetary Regime and State Bank, Law on Financial Institutions, Reform The Economic Transformation Act and Labour Code, among others.

The Central Bank of Ecuador in the Dollarization

The Central Bank of Ecuador must continue to act as “trusted third party” in its relations with the public sector and the private financial system. In this sense, the institution’s mission is to promote and maintain economic stability in the country for which it must meet the following:

o Contribute to the design of policies and strategies for the development of the economic program, and

. Run the monetary regime of the Republic, which involves managing the payment system, investment reserve free availability and act as a depository of public funds and fiscal and financial agent of the State.

Derived from this mission, the economic role of Central Bank of Ecuador, are:

Realize a continuous assessment of potential internal and external shocks that may alter the flow of the national economy;

To identify the means of transmission of these shocks, anticipate and determine the length and design and implement response mechanisms: stabilization funds, recycling operations, among others;

. Monitoring the consistency of economic policy in the country, provide for their internal and external consistency and recommend adjustments to the national government

o Identify the most vulnerable sectors of the economy;

Define and control the variables that determine economic growth and liquidity

. Making theoretical and empirical studies on the structure and evolution of the economy in the medium and long term;

. Develop summary statistics and forecasts in areas monetary, fiscal, external, real and financial.

Similarly, microeconomic functions relevant to the development of the economy that correspond to the Central Bank, within the existing system, are summarized in:

. Run the currency system;

o To provide the money supply to the economy;

. Manage and regulate the payments system;

. Manage locking system;

. Manage the accounts of public and private financial entities subject to the reserve;

. Manage the process of exchanging sucres (notes and coins)

. Monitoring financial risks;

. Manage fixed assets and financial

. Manage the assets and international reserves;

. Recirculating financial system liquidity;

. Make the service of internal and external public debt and,

o Provide services trade.

4. Dollarization monetary instruments

Interest rates

The Economic Transformation Law, established the rates desagio. Consisted of an adjustment, for once, the lending and deposit rates, effective January 11, 2000 In regard to the maximum conventional interest rate on which is a crime of usury, shall be determined by the Directory of Ecuador Central Bank, taking into account the current benchmark lending rate at the last full week before, plus a surcharge of 50%

Liquidity Operations

Another fundamental changes referred to in the Economic Transformation Law is the limitation of open market operations to the recycling of liquidity in the financial market. On March 21, 2000 the Board of the Central Bank of Ecuador enacted the relevant provisions, so that the placement of Central Bank securities (TBCs) is limited to pick up excess liquidity and, if necessary, be used to meet temporary demands liquidity of the financial system.

Lace

In consideration of the dollarization scheme, the reserve plays an important role in the proper functioning of the payments system, the Central Bank decided to realign the instrument. On January 26, 2000 [7], the Board amended the provisions of banking, setting a single rate for sucres and dollars, taking into account the weighted average required reserve to sucres and dollars reached 11%, lowered in a first phase at a lower level, 9%, which was applied to the total deposits and borrowings in sucres and dollars. Subsequently, the reserve was amended, the effective tax rate is 4%.

Changes in the statistical information

To accommodate the dollarization scheme, the Central Bank has made profound changes in economic statistics, respecting international standards and definitions. The new scheme has been forced to make changes in the development of economic statistics, because it represents a structural break in regard to the design, definition and presentation of monetary aggregates used in the design and monitoring of economic policy

Some Lessons About the dollarization process

Mutual support between dollarized countries and will be vital to learn from the experiences, successes and failures of each. Should contemplate the possibility of developing joint proposals to ensure the viability of this scheme.

Dollarization has eliminated the risk of a currency crisis, associated with capital movements and allow a reasonable amount of time the interest rates and inflation is at international levels. The balance of this experience has been positive, despite the consolidation process should be ongoing and permanent. It is therefore essential to continue with the effort to adapt the system processor and the main sectors of the country to the requirements imposed by the current scheme.

While it has reduced the flexibility to address the liquidity problems of the financial system, it is precisely this limitation which should result in major initiatives of the bank to define strategies to strengthen it.

Moreover, the speed of convergence of prices towards international levels, has been subject to a number of factors discussed below.

5. Inflation

One objective of dollarization is the convergence of domestic prices to international levels. After a year in dollarization has not been able to reduce the variation in prices. As of February 2001 the annual inflation reached 67.2%.

This behavior of growth rate of prices of goods and services, is explained by:

I) The rapid depreciation of the exchange rate in 1999, which triggered a strong inflationary inertia and interactive adjustment of relative prices.

II) The revision of rates of managed services: electricity, water, telecommunications and transport

III) The process of rounding on the relative prices, bolstered by a recovery in demand inelastic to price increases (household consumption, imports).

IV) The loss of reference prices in dollars, prices have been removed in sucres, as there is no public reference on the evolution of prices in places of sale of commodities.

V) The desire to maintain a constant profit margin by the merchants.

VI) The expectations of the agents face major decisions such as the revision of prices of public goods such as fuel and gas

Fiscal Management

Monitor the fiscal situation of the sector under the new monetary scheme, is the main focus of economic policy, which support and define the path of economic growth in the medium and long term.

Beyond short-term evolution of fiscal accounts, structural reforms are adopted within the field of taxation and regulations that accompanies the process of dollarization, let this sector face the demands imposed by this scheme with relative success.

In this sense, the reforms envisaged in the Law on Public Sector Budget added principles of fiscal responsibility, including:

I) Sustainability: the Ministry of Finance may not make a Proforma Budget that includes a deficit of nonfinancial public sector than 2.5% of GDP.

II) Conservatism: opt for the pro forma budget that provides prudent and realistic projections;

III) Transparency: the Ministry of Economy and Finance shall submit to Congress a semiannual report on budget execution and,

IV) Fiscal balance: on the average three-year periods of fiscal results for the three years should generate a fiscal balance.

Reform of the Stabilization Fund, created in 1998, which regulates the fate of the oil revenues are not expected or higher than initially contemplated in the budget approved by Congress.

You’ve signed the contract for the construction of heavy crude pipeline (OCP) that most of the improvement of future oil export revenues, have a significant multiplier effect on labor demand in foreign direct investment in a partial increase in deposits in the financial, construction, transportation and food production.

It has developed a tax reform proposal aimed at simplifying and streamlining the tax administration.

At the short-term, the accounting of non-financial public sector showed a surplus in 2000, this situation

is explained by:

I. The evolution of Ecuadorian crude oil prices in the international market, which stood at an average of 24.5 dollars per barrel.

II. The increased tax revenues resulting from the recovery of economic activity and improvements in tax administration.

III. The reduction in expenditures.

In terms of modernization, the Government has made significant progress towards ending the monopoly in the telecommunications sector by allowing private sector to deliver this service.

Trade Policy

The dollarization process imposes severe demands on the export sector, as they no longer have the exchange rate as an instrument to provide a comparative advantage. In addition foreign exchange flows into the country from exports will be vital to provide the necessary liquidity to boost the productive apparatus. While there has been a deterioration in the real exchange rate as a result of the slow convergence of inflation to international levels, has initiated major reforms to boost external competitiveness, including:

o Creation of the National Competitiveness Council

. Review of tariff policy

. Continuation with the process of harmonization of trade policies within the World Trade Organization (WTO), Free Trade Area of the Americas (FTAA) and the Andean Community of Nations (CAN)

These requirements of the model, adds the current global context, which is framed within a multilateral and regional trade negotiations. In this sense it is a priority to define national interests in these negotiations, taking into account the future consequences of their commitments. Moreover, it is clear that trade policy must be integrated financial services markets, transport and telecommunications. In this sense, there is need for progress on institutional redesign and improvement of the working teams to account for the increased demands imposed by these sectors. Greater integration in international markets essentially requires greater productivity, which is subject to the progress made in incorporating technology in production processes, development of physical infrastructure and business management. The external sector performance in 2000 was characterized by a large influx of foreign exchange due the favorable performance of oil prices in international markets. Non-oil exports did not reflect the dynamism expected, due to problems both in volume and export price. For their part, imports showed a recovery, with the largest increases in the areas of raw materials and consumer durables. As for the main markets to be addressed by the offer of Ecuadorian products, our main trading partner is the United States of America. Therefore, the challenge remains the diversification of export products and their markets.

Financial Sector

In the financial field is advancing structural reforms necessary to strengthen the institutions that comprise it. There is a schedule that you stick to it, which aims to make the financial system institutions observe the criteria consistent with the requirements of international oversight.

While the polarization disappear Central Bank functions as a lender of last resort has created mechanisms such as cash flow and liquidity fund in order to modulate the temporal needs of the financial system resources. The mechanism of circulation of liquidity in the financial system aims to collect the excess liquidity by issuing central bank bills (TB), and channel redistribute evenly through repurchase agreements to financial institutions to submit temporary liquidity needs and can not sufficiently access the interbank market. Thus, reducing the risk of financial system to prevent temporary liquidity problems of some financial institutions are perceived as solvency constraints.

The liquidity fund, which manages the Technical Secretariat of the ECB, for its part allows financial institutions to the fund contributors who face temporary illiquidity, as determined by the Superintendence of Banks, access to these resources to fill gaps clearinghouse or requirements arising from foreign trade transactions subject to reciprocal credit agreements with the Central Bank.

Economic Activity

Economic activity in 2001 showed signs of recovery. Virtually all sectors of the economy had registered negative rates of change in 1999, a situation that was reversed in 2001. The path of quarterly GDP increases of 0.5%, 2.4% and 2.0% in the first three quarters of 2000. The oil and mining activity resulted in a major boost to economic growth as well as manufacturing and construction.

Conclusions

The sovereign decision of dollarization of the Ecuadorian economy, not just a decision to change the currency regime. In addition to requiring far-reaching reforms in the economic field has had to venture into other fields such as cultural, educational and political. The deviation from the objectives of stability to ensure the success of dollarization would be more expensive under the current scheme, which in any other context. It is for this reason that efforts are being undertaken in the financial, fiscal and external are paramount. It is important to share some experiences that have resulted from this process. Among the advantages of dollarization can include the following:

Annul exchange rate expectations, improving the predictability of key economic variables

Reduces the inflation caused by printing money

Reduces transaction costs arising from trade that is associated with currency exchange.

. Reorient the debate on key issues such as competitiveness, productivity and stabilization mechanisms

Have exposed some of the problems still facing the dollarization:

o The delay in the convergence of domestic inflation to

. The domestic interest rates that are real, although negative, are also on international rates.

6. Two Years Later

Introduction

After two years of dollarization there is even the perception that the process of dollarization in Ecuador began, can be affected by economic events that will reverse as those that impair the purchasing power of the United States dollar.

The most severe enemy of dollarization is undermining the solvency of the currency we use which would cause confusion with handling money a dollar Ecuador, but now with two-year process has become irreversible.

Monetary stability was achieved which resulted in the restoration of the ability to help save the availability of resources to meet short-term investments and sustain a growing pace of consumer items, even those of longer duration.

The main disadvantage is that you get a grip on inflation, despite its reduction.

The adoption of dollarization in the medium and long term must be accompanied by an increase in the standard of living of the population. Dollars unnecessarily entering the Ecuadorian economy through exports as the main category, exports of oil, and as second provision of Ecuadorians living abroad and the behavior of remittances in the short term are the monies that Ecuadorians sent abroad to Ecuador in the country, these resources in the last four years have leveled off at around 1200 million in 2000.

The other is expected to increase foreign investments, directly or indirectly. The OCP is one of the most promising investments completed in 2003. But ultimately the foreign investment has not grown due to the low relevance of country risk rating given to us by organizations such as Moody’s, STANDARD & Poors, EURO MONEY.

You need to add external loans granted to public or semi-public sector by the IMF, IDB, CAF, or BM. Used to inject liquidity into the monetary reserve Freely Available (RMLD) and contain fertilizers and interest payments on external public debt of Ecuador.

Ecuador needs to foster a work ethic, culture in TIMELINESS, develop habits of saving overall and discard the negativity that does great damage to the targets set in the country. Let us follow the example of football, and at last get together before our country.

The economic movement of 2001 was repeated in 2002.

Therapy achieved automatically dollarization stabilization in monetary and exchange, interest rates and dollar exchange rate respectively. Unfortunately, micro-economic level there was the same effect on the production nor in the structural field.

Nor improve the internal conditions for Ecuador becomes competitive.

The external debt burden depends on the efforts being made to reduce it to medium term, instead of down $ 263 million increase between 2000 and 2001.

The elimination of risk assessment and exchange rate uncertainty is a good expectation for investors without fear that your money loses purchasing power.

Dollarization eliminated one of the factors fueling the inflation and rising interest rates in the market. Put the brake on the deterioration of wages of workers and the growth of debt.

There are four Achilles heels of the current system has to face: foreign trade, government expenditure, external debt and the financial system.

From January to November 2001 exports accounted for 4.143 billion dollars, a drop of 10.47% over 2000. It is said that there was an increase of 5.4% of GDP in 2001 but who continue Ecuadorian Why. Note that the IRS is the most respected institution for its strength in tax revenues.

Viewpoint De Carlos Julio Emanuel

* Two years of dollarization How to prevent the lack of competitiveness press the scheme.

A: The government’s concern is obvious. For this reason it is an aid to achieve competitiveness in the central idea is to reduce the cost Ecuador. The tool to do so is to reduce lending interest rates and economic recovery.

* How dollarization work with less resources next year if the Factoring Oil becomes reality

A: As we all know the amount of money in the economy depends on the situation of the external sector and within it one of the main sources of revenue are exports of oil at the current year’s cash income used next year would restrict the amount of money in the economy next year, in an environment in which exports drop due to problems of competitiveness and the global economic downturn.

* What would you do to reduce the interest rate over the past two years remains stagnant at 16%.

A: The interest rate goes hand in hand with inflation, as this indicator under 90% in 2000 to 22.4% in 2001, and next year will be less than 10 the interest rate will converge towards that level.

* Dollarization is an exchange scheme that requires an economic model is not to fail What has been done in that direction.

A: The structural repairs spoken ten years ago, were executed by this regime. Among them are: the establishment of the OCP, the extension of the SOTE, the pension reform will soon be privatized electric.

Figures

In 2001 closed its activities with $ 724 million interest payment, $ 780 million of amortization, the current account with a negative balance at -5% of GDP, an estimated price of oil at $ 16 per barrel average, the financial gap skirts $ 500 million versus multilateral disbursements.

The establishment of the OCP will inject foreign investment and boosting employment, and exports up in this year 2002 but the new own resources just are expected late 2003.

Growth close to 5% of GDP and lower inflation to 22.4% of the Ecuadorian economy being the star of Latin America in 2001.

* The process of oil is uncertain, with $ 16 in a forecast $ 13.5 optimistic and pessimistic.

* A December 2001 inflation of 22.4% annually, 0.7% 22.4% accumulated monthly.

* The competition is offset by a real exchange rate of 100 points or less.

* Inflation continues to decline.

* Interest rates upward trend in Dic/2001

15.1% active

5.1% Passive

Interbank 2.7%.

* Employment is up by reactivation but does not cover the basic food basket.

* An unfavorable trade balance and high debt payments, become critical, the resources of emigrants and foreign loans.

* Improve the use of the pair falls underemployment and unemployment.

October 2001 Total unemployment 9.5%

October 2001 total of 47.4% underemployment

* There are better nominal wage increase of 24% from $ 47.7 at the end of 2000 to $ 121.3 in January 2001. Dic/2001 $ 146.1 with a real salary (Agost/95 = 100) of 100.6%.

* Family income does not cover the basic food basket that borders the $ 313.6 at December / 2001.

* If we talk about competitiveness. It is time for it is one of the main objectives, although the ranking of global competitiveness index in 2001 we ranked 72 of 75 and is expected to go better and better.

* The competitiveness rests on two pillars: the economic and social, the first with the investment environment and the second to education.

7. Conclusions

The trade balance was negative in 2001, the country bought more than sold. The trade deficit reached U.S. $ 508.6 million, imports grew by 50%, therefore the Ecuador became a consumer nation and the productive apparatus is still stalled.

Dollarization is not yet in just two years to assess therefore the objectives proposed by the Central Bank to operate the model has ups and downs that will dissipate over time is true that some are true and others not.

Sources:

* Analysis Research

EKOS Economics and Business * # 80-13

January 2001 – January 2002.

– Economy and Management Company # 87-91

September 2001 – January 2002.

* Www. bce. end. ec

* Www. SRI. gov. ec

* Www. Dollarization in Ecuador. com.