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AmericasAugust 3 2003

Adopting the greenback brings mixed fortunes

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Countries which have swapped their national currency for the US dollar have not found the strategy to be an immediate success. Monica Campbell reports.The idea of dollarising a nation’s economy is considered either a political impossibility or a high-stakes policy gamble. But, in recent years, two Latin American countries, El Salvador and Ecuador, have taken the leap. Each came to the US dollar under distinct circumstances and their performance so far under the greenback is mixed.

On New Year’s Day 2001 El Salvador became the third Latin American country – along with Ecuador and Panama – to exchange its currency, the colón, for the dollar. Cash machines spat out dollars and bank accounts were converted. The changeover was rapid. Lawmakers had only passed the dollarisation legislation on November 30th 2000, following a publicity blitz using the slogan “Good for you, good for the country”. Some convincing was in order. The idea of dumping the colón, a national symbol, for the “Yanqui” dollar made some Salvadoreans wince, as memories were still fresh of the US funding the notorious right-wing government during the civil war in the 1980s.

The timing of the switch, however, proved useful to attract foreign aid following a devastating natural disaster. On the morning of January 13th 2001 – nearly two weeks after the dollarisation process was set in place – an earthquake ripped through El Salvador. Nearly 1000 people died and some 145,000 homes were destroyed. Soon afterwards two more earthquakes caused further damage. It would take billions of dollars to recover. The relatively painless switch to the dollar – a signal to outsiders that El Salvador housed a sound financial system – convinced outsiders to help fund the reconstruction efforts. The government was able to successfully sell bonds to the foreign market.

A lasting effect of the switch to the dollar has been a steep drop in interest rates. Without the risk of sharp devaluations, the average interest rate in El Salvador fell from 14% in 2000 to 7.8% in 2001 and reached a record low of 6.5% this April. Although the decline in lending rates has yet to boost credit growth substantially – owing largely to an economy still struggling with a weak external trade climate – the move to the dollar is expected to benefit the financial sector in the longer term. “The banking sector is active and competitive now. There are more mortgages out there; people are able to invest in the businesses easier. I’ve heard of people getting access to 3% interest rates. Halleluja,” says Claudio de Rosa, director of El Salvador’s national banking association.

Ecuador’s experience with the dollar has proved tougher. In early 2000 it replaced its national currency, the sucre, with the US dollar in order to pull out of a devastating economic crisis that involved a debt default, a crumbling banking system and a steep devaluation. Dollarisation was the last resort, after a variety of currency exchange schemes – fixed exchange rate systems and crawling pegs, for example – were tried without luck.

For then-president Jamil Mahuad, dollarisation proved to be a political death knell. The uncertainty over the future of such policy only added fuel to attacks on him. Eventually, military officials joined increasingly active opposition leaders, leading to a coup d’état. Civilian rule was soon re-established and the Ecuadorian Congress eventually passed law allowing for full dollarisation.

Policy continuation

The authorities fixed the exchange rate at 25,000 sucres to the dollar and gradually withdrew sucre notes from circulation. Mr Mahuad’s successors, Gustavo Noboa and the current president Lucio Gutiérrez have moved ahead with dollarisation without losing their office.

“It was a grand scheme to stabilise the economy and financial sector. And it worked for the most part,” says Fernando Pozo, general manager at Banco Pichincha, Ecuador’s biggest bank.

Indeed, Ecuador’s economy grew by 5.1% in 2001 and 3.4% last year, up from a 6.3% GDP contraction in 1999. The inflation rate averaged 12.5% last year, down from 37.7% in 2001 and 91% in 2000.

One perk for Ecuador (and El Salvador) was the elimination of the costs of exchanging one currency for another – key in a country where cash sent from relatives working abroad (mostly in the US) totalled $1.4 bn last year, the second-largest source of foreign exchange after oil.

At the end of 2002, real interest rates were much lower, at 7.1%. Bank deposits are now returning and the financial system is beginning to re-establish itself after a commercial banking collapse in 1998-1999. However, there is still a wide gap between lending and deposit rates. Also, the once-crowded banking sector is now ruled by a small handful of banks, so competition is scarce.

Productivity problems

The dollar has also put the squeeze on public and private workers in Ecuador. Exporters, especially, say that they are less competitive when compared with their non-dollarised South American counterparts. “Private companies have needed to buckle down and become more productive,” says Mr Pozo. “The government also has to be fiscally responsible and put the brakes on giving public workers raises at politically-opportune times. Some people don’t like these changes, but they need to happen.”

Dollarisation does require a government’s budget to be balanced every year. Panama, which adopted the dollar years ago, has posted deficits in recent years without repercussions. However, it does imply that deficits are to be financed through straightforward and transparent methods. This can mean adopting initiatives that call for higher taxes or more debt. These policy moves are unpopular in a country like Ecuador, where real wages have not gone up with dollarisation and unemployment remains high. When President Gutiérrez, a leftist whose campaign was ripe with pricey populist pledges, attempted to hike the cost of fuel recently, violent protests erupted. Work stoppages led by teachers, labour unions and health workers are growing more common. The tense political climate has stalled proposals to open up the oil industry to private investment and rework public worker wage scales.

Economic reforms

“The first step was taking on the dollar. But without the second step, which means real reforms and better fiscal footing, we’re going to have problems. We won’t be able to respond to economic shocks,” says Mr Pozo.

True. An officially dollarised country gives up its ability to respond to economic crisis by, for example, increasing oil prices or churning out more money. It also loses its domestic central bank as a lender of last resort. “Washington decides our monetary policy now,” says Marco Antonio Quevedo, chief financial officer at Cemento de El Salvador, one of the country’s largest firms. “I appreciate the change to the dollar, but what’s good for the US is not necessarily good for us. If the US economy starts to steam ahead again, interest rates will rise and that spells trouble for us since our debt is denominated in dollars. We also import parts from the European Union, so if the dollar loses value to the euro, there’s another problem.”

To defend themselves, governments can tighten their budgets and try to increase capital flows. Central banks can also help to protect the financial system. “We focus now on enforcing and modernising regulations and putting out as much information as possible on the state of the financial sector,” says Luz Maria de Portillo, El Salvador’s central bank president.

In all, dollarisation should not be a cure-all for any economy. Despite its relative success in El Salvador, joblessness and a high poverty rates persist and remain at the front of public debate.

With presidential elections set for 2004, the chief opposition party, the left-wing Farabundo Martí National Liberation Front (FMNL), is tapping these frustrations – and also rising anti-Americanism – by saying that dollarisation was a sell-out to Washington. But their arguments tend to fall flat with most Salvadoreans.

Perhaps most of all, dollarisation’s biggest impact is psychological – using the most trusted currency in the world can reduce anxiety. “Dollars are what people hide under their mattresses. They’re what you receive from families abroad. There’s comfort in that,” says Mr de Rosa in El Salvador.

Hopes for future

For Ecuador and El Salvador, realising the full benefits of dollarisation may not come until better political and economic times set in worldwide.

“We really haven’t had a break,” adds Mr de Rosa. “First, there were the earthquakes in 2001, and then the problems in the US economy. But I’m hopeful. I think we’ve got a good system in place that will only help us in the future.”

Incorporating the greenback could make things easier once hemispheric-wide trade pacts – such as the Central American Free Trade Agreement or the more ambitious Free Trade Area of the Americas – get off the ground. “It could make the process of trade integration easier, certainly. But dollarising is a very careful process. The margin for error is very small and any slip carries high costs. No surprises are welcome,” said Ms de Portillo.

Guatemala may be the next candidate for dollarisation in South America, insiders say. The country already has approved the use of dollars in addition to the quetzal, its local currency. But no politician there will have the bravery to take up the debate until well after the presidential elections that are set to take place this November.

Learning to love the dollar

the quick switch to the dollar from the colón in El Salvador left some Salvadoreans grappling with an awkward official exchange rate of 8.75 colóns to the dollar.

Also, with El Salvador’s illiteracy rate at about 20%, it helped that a twenty-five colóns bill was blue, a two hundred, red, and so on. The colour-coded system did not require knowing how to read in order to perform transactions. Dollars are not designed that way and some people were wary of getting tricked (the value of a fifty-cent piece, for example, appears nowhere on the US coins) or receiving counterfeit bills.

There was also the one-off cost of converting prices, computer programmes, cash registers, and vending machines to the dollar. Now, the kinks have been ironed out and everyone from taxi drivers to tamale vendors handles it with ease.

Most Salvadoreans agree that the change was a smart one. For most of the 1990s the colón was largely fixed to the dollar and business transactions in the foreign currency were common.

“We had a stable exchange rate and a good amount of international reserves. The financial system was pretty solid,” says Luz Maria de Portillo, El Salvador’s central bank president.

“Dollarisation was a chance to build on this momentum, while also helping to attract foreign investment and lower interest rates.”

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