De-dollarization has becomes inevitable. And Correa’s track record shows it will likely be quite messy.
The year 2011 has started with extraordinarily tumultuous events, from the crisis of the Arab World to the Japanese earthquake and tsunami. While the revolutions in many Arab countries provided Ecuador with a surprise bonanza, the waves that barreled across the Pacific, damaging some infrastructure on the coast and the boats of fishermen who couldn’t carry them to high ground in time. Both serve as reminders of how Ecuador faces unexpected risks with a currency system that, after more than a decade, remains incompletely installed and thus at risk. Much has been said about rampant government spending. While it has exploded and the government faces severe corruption allegations, in real terms, it has remained near long-term average rates. President Rafael Correa has meanwhile toned down his rhetoric against the dollar, instead saying that his administration has done more to protect his voters' cherished greenbacks than all of his predecessors.
Nevertheless, there are no signs the government wants to seriously address long-term threats, as the half-hearted courting of foreign investors shows. It also has some figures to back up its claims. Government spending has helped keep consumption higher, as has the constant rise in the minimum wage. The administration ordered massive annual increases of the latter to the current $264 per month, up 33.3 percent from $198 when Correa took office. At the current level, the total income of a typical family in Ecuador - 4 members and 1.6 income earners - allows for the purchase of 89.8 percent of the value of a basket of goods and services to cover basic needs, up from 65.9 percent in 2007, providing real gains from their perspective.
This has also increased the government tax take, not least via revenue from value-added taxes. Overall, tax collections rose from 10.8 percent of gross domestic product in 2006 to 13.8 percent in 2010, while the rise in nominal tax collection during 2010 alone was 17.5 percent, exceeding by almost 4 percent the budget goal set in late 2009. At the same time, the official unemployment rate has dropped, contrary to conventional wisdom about the rise of the minimum wage, which has by far outpaced any productivity gains. The surveyed urban unemployment rate fell to 6.1 percent as of last December, below the 7.9 percent observed a year earlier during the global recession, and even lower than the 7.3 percent rate in December 2008, the month the US National Bureau of Economic Research marked as the beginning of the recession there. The underemployment rate has shown slower declines however and some economists suspect the cheery jobs data comes from a fall in the work force, meaning the situation for many would be so dire that they’ve given up on looking for a job. Ecuador of course can’t devalue to cheapen its labor.
One of economists' mantras has been to recommend loosening of regulations, as firing costs keep many potential employers from hiring and many workers outside the formal economy. Worse still, the Constitutional Assembly, dominated by Correa’s political vehicle, exacerbated the problem by prohibiting almost all part-time work. The November 2010 “código de la producción” backpedals slightly, however real reform is nowhere in sight.
Dollarization imposes severe additional restrictions on policy a maverick like Correa naturally despises. Most obviously, a government can’t devalue to improve overall competitiveness, and no lender of last resort can provide cash during a crisis. Lacking the right to print money, it should guard its liquidity carefully, and ensure that banks remain highly solvent to avoid cash crunches. In the case of Ecuador, this requires additional care given that its small domestic market means that foreign trade accounts for some 40 percent of gross domestic product. Some economists also recommend attracting foreign banks to benefit from their potentially greater liquidity than that of smaller local banks, as they do in Panama. This in Argentina however, according to the United Nations' Economic Commission on Latin America and the Caribbean, exacerbated the 2001-2002 crisis as headquarters moved to save their funds overseas. In the case of Ecuador, foreign banks have been leaving, although unlike the Argentine situation, no alternative currency exists that could contribute to currency speculation.
When Ecuador replaced the sucre with the dollar, additional reforms were planned to allow the economy to be more flexible and better prepared for shocks like a fall in the price of oil. But as the economy stabilized amid a recovery cycle, the political drive faltered and then went into reverse with Correa’s arrival as he had funds to build up reserves eliminated. Additionally, he nearly entirely severed ties with the International Monetary Fund that could provide crucial funding in the event of a balance of payments crisis. The 2008 default on foreign debt exacerbated the situation, though the use of the dollar helped to cushion the blow. If Ecuador had had a currency of its own, it would have plunged, increasing a feeling of crisis among residents.
According to the government, taxing capital exports and forcing banks to repatriate customers’ overseas deposits has instead helped maintain dollarization by keeping liquidity here. Ironically however, this has inverted the normal role of bank regulators as controllers of risk: Banks have been forced to lower fees and interest rates while being cajoled to lend more, while the banks after the severe crisis before dollarization have pursued more conservative policies, hoarding liquidity. Further regulations have undermined confidence, including intransparent government borrowing and accounting of central bank gold deposits. Foreign markets for Ecuadorian goods are meanwhile shrinking and the trade and current account deficits have reached problem levels. The government is reacting by imposing import restrictions.
As Correa has said, in an international recession, Ecuador suffers several blows at the same time. The price of its exports – above all, oil – falls, and its overseas workers' ability to send money home as their jobs disappear. Additionally, in case of a flight to quality, the dollar may well rise, undermining competitiveness, and international liquidity becomes even harder to attract. At this time, a crisis most likely will stem from a sudden outside event, like this year's foreign crises or a domestic earthquake, for all of which Correa has left Ecuador poorly prepared. Since announcing a hedge on oil income in 2009, nothing has happened. But while the clock is ticking, it lacks a face to tell people when time has run out and de-dollarization becomes inevitable. Correa’s track record shows this would most likely be quite messy.
This commentary originally appeared in Ecuador Weekly Report published by Analytica. Republished with permission.