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COMMENTS ABOUT

THE MACROECONOMIC SITUATION IN ECUADOR

Enrique Lasprilla R.

Quito, February 22nd

2000

ADVANTAGES AND DISADVANTAGES OF

DOLLARIZATION IN ECUADOR

Assuming that the conditions required for the dollarization process are fulfilled in theEcuadorian case, which has not been proven so far, it has some advantages anddisadvantages that are important to analyze in this specific case. The main advantages

foreseeable are: control of inflation in the medium and long run, control of the loose ofpurchasing power of salaries, reduction of interests rates, control of capital leakage,elimination of money exchange risks , improvement of country-risk position, economy

planned in the medium and long run directed toward productive activities, eliminationof indexation of prices, salaries and contracts, credibility of the system if it works fine,and decreasing financial costs; an small international monetary reserve is required.It is expected that in the medium and long run inflation will decrease sharply,nevertheless in the short run inflation has been growing in a very important magnitudeand has not stopped so far, because there is a gap between the trend of devaluation andthe trend of inflation. Additional price increases are expected in items such as gasoline

because they have been approved to finance the state budget; in public services(electricity ,gas, telephone and water supply) that now are subsidized; these subsidieshave to be cut out so the public companies can be sold in the international markets inorder to get resources to guarantee the regular functioning of the economy. Along withthese price increases would come other price increases as public transportation andgeneral prices of goods and services derived of the increases mentioned.The loose of purchasing power of salaries would also come to a halt in the medium andlong run because of low levels of inflation and because there are no more devaluation ofthe currency; the problem now is that salaries levels are too low due to the huge rates ofdevaluation and inflation that Ecuador has experienced during the last two years. It will

not be possible to restore the former salary levels for employees in the public sectorsince government will be tied by the need to maintain the fiscal equilibrium. In the

private sector of the economy raises in salaries will depend upon the conditions offactories and companies. Great companies will be able to increase salaries as their

businesses improve, but small businesses are unlikely that could go on with significantsalary increases.

Another expected effect of dollarization process is that the interests rates will fall slowlythrough time because there will not be the exchange risk anymore, and because if thescheme works well the risk-country will diminish. So far, the government decreed aconversion of interests rates of credits given in Sucres to its equivalent in dollars.

Nowadays, the interests rates in dollars have not fallen and its level for the transactionsrenewed are about 20-25 % yearly. New credit operations have not been opened lately.

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On the contrary, the interests rates in dollars for the frozen resources in the financialsystem are fixed at the 7% level. In case the interests rates in dollars decline thefinancial costs of the economic agents looking for credit would go down.

There would be some confidence that the leakage of capital resources from the country

would cease and resources that went out the country would return; nevertheless themechanism that is being used to defrost the money deposits in the financial systemfrozen in March 1999, do not deserve trust from the public due to the fact that alldeposits higher than 4000 US$ will continue to be frozen at least for 3 or 5 years more;this mechanism reveals that the financial system is not strong enough to face thedollarization process. On the other side, the International financing institutions and theinternational community has not given a strong support to the dollarization process ofEcuador; they seem to be waiting for the results of the experiment. Anyway, it will takesome time for the confidence in the financial system and in the economy as a whole to

be restored..

There is no doubt that the money exchange will disappear at least while the exchangerate is kept fixed. Another important issue is that if the dollarization prevails theeconomy would have to be directed to productive and not to speculative activities. The

problem is that the productive activities have to be directed toward the foreign sectorsince the domestic sector is completely depressed. Under such situation arises the issueof efficiency and productivity. Too much would have to be done for reaching therequirement mentioned. As an example, it is possible to say that only 9 factories in thecountry are applying the ISO 9001 standard , which serves as accreditation certificateto inter in foreign markets.

Among the disadvantages of the dollarization process it has to be point out that thecountry would be dependant of changes in the political economy of the United States ofAmerica; we have to be aware that their economic policy will never be takenconsidering the requirements or the economic conditions of Ecuadorian economy.Besides it is necessary to take into account that the export goods and services ofEcuador, like, oil, bananas, shrimps, coffee, cocoa and flowers are very fragile and thecountry do not have capacity to answer to sudden and important price fall downs of the

prices of these goods.

Another weakness, in the case of Ecuadors economy is the exposure to the financialinstability of the foreign financial markets, or economic crisis in the world, which may

occur anytime.

With the dollarization process there will be a loose of the revenues due to seigniorage,that is to say the benefits for issuing the local currency; Ecuador will not issue moreSucres, so it will not receive revenues for this concept; the seigniorage will be received

by the United States Government. In order to reduce the loss of seigniorage theEcuadorian Government could request to the US government the share of seigniorageonce the country become officially dollarized.

It is expected that the dollarization process will cause serious problems to medium andsmall industries and companies; it is very likely that they do not have the capability to

face the narrowness of the domestic markets, and will not be able to reach the efficiencyrequired to compete in the international markets; such situation may be leading to the

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bankruptcy of small companies and to increase the level of unemployment at thenational level; it is known that the level of unemployment now, without thedollarization process being implemented is around 18%.

Right now, the low level of salaries and the high rates of exchange in relation to other

currencies are comparative advantages that facilitate exports to other countries speciallyto the neighbors (Colombia and Peru) But as time passes these comparative advantageswill progressively be lost, because the economy will be tighten by the dollar. In themedium and the long run, it will be more advantageous to import than to export goods.

Under the circumstances described people who will benefit from dollarization will bevery few and the income distribution will be more inequitable than it is now. The gap

between the reach and the poor will broaden.

There is a law project in order to establish the dollarization in the ecuadorian economyand it seems to be that it will be approved by the national Congress; so Ecuador is next

to start a trip without return.