Uh-oh, it looks like your Internet Explorer is out of date.
For a better shopping experience, please upgrade now.
Currency Unions reviews the traditional case for flexible exchange rates and "countercyclical"—that is, expansionary during recessions and contractionary in booms—monetary policy, and shows how flexible exchange rate regimes can better insulate the economy from such real disturbances as terms-of-trade shocks. The book also looks at the pitfalls of flexible exchange rates—and why fixed rates, particularly full dollarization—might be a more sensible choice for some emerging-market countries. The contributors also detail the factors that determine the optimal sizes of currency unions, explain how currency union greatly expands the volume of international trade among its members, and examine the recent implementation of dollarization in Ecuador.
About the Author
Read an Excerpt
By Alberto Alesina, Robert J. Barro
Hoover Institution PressCopyright © 2001 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
Ecuador and the International Monetary Fund
Ecuador's decision to dollarize was taken in January 2000 by then President Jamil Mahuad, who only a few days before had described the idea as "a jump into the abyss." So it seemed. But although President Mahuad lost his job within two weeks of taking the jump, dollarization in its early stages has turned out more successfully than almost anyone expected. However, the story is not yet over, and in the words of the IMF's unofficial motto, "complacency must be avoided."
I outline some of the key economic events and decisions leading up the dollarization decision, describe what has happened in the Ecuadorian economy since then, and note some of the challenges that the Ecuadorian government still faces.
Ecuador's economic history has not been a happy one. A lack of national cohesion has dogged the country ever since it opted for independence from Simon Bolivar's Grancolombian Federation in 1830. From the start there was fierce rivalry between the residents of the highlands, centered on the capital Quito, and those on the coast, centered in Guayaquil. Fortunately, though, these rivalries did not lead to violent confrontation, and Ecuador's history, although turbulent, has been peaceful. However, the deep split between the interests of the coastal and highland regions has at times — and certainly during the last five years — made it almost impossible for the government to pursue a coherent economic policy.
In the mid-1990s, Ecuador's GDP was about $20 billion, with exports amounting to 20 percent of GDP. Half these exports were oil, which was discovered in the 1960s and came onstream in the 1970s. Bananas and shrimp were important too. By 1998 GDP had fallen to less than $18.5 billion, and by 2000 the massive overdepreciation of the currency had cut this to $13 billion — for a population of 12.5 million. In 2001 GDP will probably rise to more than $17 billion.
Ecuador's last good year economically was 1994, during the presidency of Sixto Duran Ballen. GDP grew by 4 percent and inflation was 27 percent. The Duran administration also decided to adjust gasoline prices monthly and automatically by indexing them to world prices. Up to that time, the adjustment of gasoline prices was always a potential political problem. However, in 1995, Ecuador fought a border war with Peru, increasing military spending and moving what had been an approximately balanced budget into significant deficit. The Duran administration lost credibility as the vice president, who had been a major force in economic policy, fled to Costa Rica to evade arrest on charges of corruption.
Popular discontent ushered in the colorful presidency of Abdala Bucaram — who was called El Loco — in the 1996 election. Bucaram came to office as a populist but almost immediately invited Domingo Cavallo to advise him. He seemed to be moving in the direction of President Carlos Menem in Argentina — who came to office apparently a populist, only to institute a serious stabilization and reform program. After visiting Ecuador, Cavallo concluded that the country did not yet meet the preconditions necessary to institute a currency board successfully. President Bucaram lost credibility as a result of other actions, including alleged corruption and cronyism.
In February 1997 the situation deteriorated into a general strike, and in a last desperate bid for survival Mr. Bucaram undid some of the reforms he had implemented; he also stopped the indexation of energy prices. Eventually Mr. Bucaram found himself barricaded in his palace, and his Congress voted to remove him on grounds of "mental incapacity." For a brief confusing period three people claimed to be president: Mr. Bucaram, his vice president, and the leader of Congress. In the end it was the congressional leader Fabian Alarcón who was appointed interim president. Lacking authority and a clear mandate, he made no effort at reform and instead tried to bolster his popularity with concessions to unions and regional lobbies. More bad luck followed with, El Niño in 1997, which caused severe crop damage and destroyed infrastructure in the coastal region, at a total cost of about 13 percent of GDP.
The situation did not degenerate into a full-blown economic crisis during the Bucaram and Alarcón governments in part because private sector investors were still willing to finance emerging markets — particularly a country with oil — in the face of falling U.S. interest rates. Chase Manhattan gave Ecuador a $300 million bridging loan in December 1996, and — just three months after the ousting of President Bucaram — Ecuador managed to issue a $500 million eurobond. It is perhaps symbolic of the emerging market euphoria at the time that Moody's gave Ecuador the same credit rating as Brazil and Argentina — and this at a time when Ecuador was in arrears to its official creditors in the Paris Club.
When Jamil Mahuad was elected president in July 1998, it looked for a while as though things might change. Mr. Mahuad, a man of intelligence, charm and integrity, had established a reputation for reform during two terms as mayor of Quito. He took office in August 1998, and his authority in the country was enhanced when he signed a final peace agreement with Peru in October of that year. But it was during his presidency that the economy degenerated into crisis.
One problem was a rapidly deteriorating fiscal position. The public sector deficit ballooned from 2.6 percent of GDP in 1997 to 6.2 percent in 1998. Ecuador's external debt of more than $16 billion was also large relative to GDP. Three factors were crucial: revenue weakness from falling oil prices, the low nonoil tax base, and big public sector wage rises. The rapidly worsening condition of the banking system further complicated the situation. Action was needed urgently to reduce the deficit, allow lower interest rates, stop the accumulation of external arrears, and reduce debt service to sustainable levels. President Mahuad visited the IMF in September 1998 and explained that he preferred to manage without an IMF program.
By the time the IMF began the 1998 Article IV surveillance discussions in late September, the government had cut energy subsidies, raised gasoline prices, hiked interest rates, and devalued the exchange-rate band by 15 percent. But it was clear that much more had to be done. We argued that the fiscal deficit should be halved and expressed serious concern about the health of the banking system — noting a rise in nonperforming loans, the drying up of external credit lines, and too much lending in U.S. dollars to sucre-based borrowers. In response, the authorities explained the political barriers to fiscal tightening and said we were overstating the problems in the financial sector. Nonetheless, on October 2, the authorities said that they did want to negotiate an IMF-supported program.
We then entered an exceptionally long and difficult period of negotiation. IMF teams were in Quito at least half the time between November 1998 and March 2000; we had an agreement in September 1999 that did not work out; and we were ready to conclude another agreement in January 2000, just before dollarization.
There were two basic difficulties in the way of an agreement. First, recurrent banking sector problems were met through a series of ad hoc actions, including a deposit freeze in March 1999 and government bailouts typically carried out without consultation. Second, related fiscal problems made it difficult to get agreed programs implemented. Political and social problems prompted further counterproductive fiscal measures, for example, the replacement of the income tax with a financial transactions tax in November 1998.
By the time an IMF mission went to Ecuador in March 1999, the country's exchange-rate band had been abandoned after high interest rates and $250 million in intervention had failed to save it. The finance minister had also resigned after fiscal tightening measures were withdrawn from the budget before it was sent to Congress.
Nonetheless, this mission made some progress. The authorities sent a tax reform package to Congress that included the reinstatement of the income tax and a broadening of the VAT base. We also agreed on the principles of a bank resolution strategy. However, the resignation of the central bank president and three board members made it impossible to reach agreement on monetary policy. The authorities also continued to favor direct bailouts of favored banks with public money. When there was a run on the Banco Progreso, the second-largest bank in Ecuador (in terms of assets), the authorities declared a five-day bank holiday and froze all deposits and loans in the bank for a year.
Two months later, Congress had approved a weakened tax package and our team was back in Quito. Despite some progress, agreement on a full program again proved impossible. With the fiscal deficit still on course for 6 percent of GDP, the president refused to push for further tightening because of looming congressional elections. Energy price rises were rolled back and the authorities were not willing to submit legislation to protect the banking reform strategy from political interference.
By late June, we were embarked on our fourth mission visit in seven months. Agreement was reached on many elements of a program, including the main details of a banking strategy. But on this occasion the discussions were interrupted by social unrest, prompting the president to freeze energy prices for a year.
We finally reached agreement on a program in August, conditional on congressional approval for the tax strategy and progress in banking reform. We expected to finalize a program by October but knew that the Ecuadorians had significant interest payments to make on external debt in late September. The authorities asked us what they should do. We said that the decision was up to them: if they defaulted, then there was a risk of disruptive legal challenges; if they paid, it would be difficult to sustain a viable cash flow position.
In the end, the authorities delivered their Letter of Intent to the Fund on September 29, announcing on the same day that they were deferring interest payments due the following day on some of their Brady bonds. A little less than a month later, the Ecuadorians also announced they would not make a eurobond payment due on October 28 and unilaterally rescheduled part of their domestic dollar-denominated debt.
Throughout this period, public support for Mr. Mahuad was declining steadily from the peak of more than 60 percent he achieved in the wake of the peace agreement with Peru. With the sucre heading south rapidly — and Ecuador in the midst of a recession that would see output decline by more than 7 percent in 1999 — frustration was mounting. The social impact of the country's problems was clear to see. The proportion of Ecuador's population in poverty reached almost 45 percent in 1999, up by a third since 1995. Meanwhile, unemployment had doubled to 17 percent since the beginning of 1998. In November and December the sense of crisis was heightened as inflation accelerated and the Sucre's decline gathered pace.
Addressing the nation at the end of the year, the president promised a drastic change in course — only to see the sucre fall another 25 percent over the next few days. His approval rating plummeted with it, reaching just 7 percent. By the time Mr. Mahuad announced the decision to dollarize on January 9, the sucre had lost almost 80 percent of its dollar value in the sixteen months since he had taken office. The dollarization decision did produce some recovery in the president's poll rating, but it was one last blip. On January 21 he was ousted in a civilian-military coup.
The decision to dollarize was taken in desperation. The authorities did not consult with us, although they did take advice from some outside advisers including the Argentine consulting group, Mediterranea, and Guillermo Calvo. If they had asked us, we would have said that the preconditions for making a success of dollarization were not in place. In particular, the banking system was unhealthy and the fiscal position was weak.
However, once the decision to dollarize had been made, the best choice was to try to help it succeed: we spoke to the president and the finance minister on the day after the dollarization announcement and said that we would do what we could to help. Thereafter we have worked very closely with the Ecuadorian government, seeking to help them ensure that dollarization does succeed and that the stability it has brought so far (albeit not yet to prices) is maintained and strengthened.
President Mahuad's successor was the former vice president, Gustavo Noboa. He opted to stick with dollarization, reflecting the widespread conviction that all reasonable alternatives had now been exhausted. After demonstrations during which a group of indigenous peoples, with the support of some members of the army, occupied Congress (an event that drove home the need for national coherence), the administration also managed to muster support for a broad-based program of economic reform, symbolized by passage of the so-called trolleybus law through Congress. As a result our Executive Board was finally able to support Ecuador's program on April 19, approving a twelve-month standby credit of $304 million. With additional support from other multilateral lenders, this offered Ecuador around $900 million over the next twelve months, with up to $2 billion possibly available from official lenders over the next three years.
Given Ecuador's large external financing needs, it was clear that private sector creditors would have to play their part. The country needed both cash flow relief and debt reduction to secure a sustainable external and fiscal position for the medium term. In line with our existing policy, we were willing to lend to Ecuador while it was in arrears to its private creditors, on the basis of an agreed program and provided the country were engaged in good faith negotiations with the creditors. Ecuador managed to secure a successful debt exchange in August. Ecuador offered to exchange all of its Brady and eurobonds (with a combined face value of $6.5 billion) for a combination of new thirty-year and twelve-year bonds. Some 97 percent of all bondholders accepted the exchange offer, which gave Ecuador a substantial debt reduction (by about 40 percent of the face value of the bond debt) as well as significant cash flow relief in the initial years. In September, official Paris Club creditors agreed to grant Ecuador a rescheduling/deferral of about $800 million in arrears and maturities due in 2000.
Private sector players have criticized our approach to Ecuador's debt problems on a number of grounds. Some claim that the IMF bullied Ecuador into defaulting on its Brady debt last year. This is not true: we made it clear that private sector involvement would be necessary, but we did not advise them what to do about specific payments.
There is a grudging acceptance now among most market participants that some coordination — or coercion — of private sector creditors may be necessary on occasion to resolve financial crises. But there are still complaints that we are too vague about the approach we will take in particular cases. This is an unfortunate consequence of the fact that individual cases vary widely and that a flexible approach is essential. On most occasions, the combination of a robust policy program and short-term financial help from the fund should be enough to restore access to private capital markets. But more concerted action to coordinate creditors may be necessary if a country faces a large short-term financing requirement and has little hope of early access to capital markets — or if its medium-term debt profile looks unsustainable.
It is interesting to note that some market participants predicted that the sky would fall if this approach were followed. But debt reschedulings have taken place for both Ukraine and Pakistan without the disruptive litigation that many predicted.
The early (and largely unexpected) success of dollarization has helped restore confidence in the banking system, promoting a rise in bank deposits and an increase in bank reserves with the central bank. But indigenous groups remain wary of the policy, and it is not yet clear that the government has finally managed to assemble the durably stable legislative coalition that has so long eluded its predecessors. It is that stability that will rekindle confidence at home and abroad and lay the foundations for an enduring recovery from the country's torturous economic problems. These foundations should include a sensible tax reform so as to replace existing highly distortionary taxes (the financial transactions tax and an import tariff surcharge) and to avoid excessive reliance on oil revenues. They also include implementation of corporate debt restructuring in a manner that does not bail out large borrowers at taxpayers' expense and a comprehensive revamping of the financial sector. And both sustainable growth and a stable political situation will be more likely with policies that invest in critical social sectors.
Excerpted from Currency Unions by Alberto Alesina, Robert J. Barro. Copyright © 2001 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Hoover Institution Press.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.
Table of Contents
|About the Authors||ix|
|1||Ecuador and the International Monetary Fund||1|
|2||One Country, One Currency?||11|
|3||Dollarization and Integration||21|
|4||An Estimate of the Effect of Currency Unions on Trade and Growth||31|
|5||Reflections on Dollarization||39|
|6||Coping with Terms of Trade Shocks: Pegs versus Floats||49|
|7||Monetary Independence in Emerging Markets: The Role of the Exchange-Rate Regime||57|
|8||Dollarization of Liabilities, Financial Fragility, and Exchange-Rate Policy||67|
|9||Do We Really Need a New Global Monetary Compact?||77|