Sovereign Risk and Dollarization in Ecuador

7/27/2019 Sovereign Risk and Dollarization in Ecuador

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SOVEREIGN RISK AND DOLLARIZATION: THE CASE OF ECUADOR

Jules Pierre, Ph.D., CFA

Finance Department

Florida Atlantic University

Boca Raton, FL 33431

[email protected]

(954) 236-1290

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mailto:[email protected]:[email protected]:[email protected]


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SOVEREIGN RISK AND DOLLARIZATION: THE CASE OF ECUADOR

Abstract

Through policy decision of governments and through other

unofficial means, many countries have moved away from

their local currency to seek protection against inflation

provided by a hard currency, the dollar. Among the

promises of dollarization is the reduction of sovereign risk

associated with developing country debts and subsequently

an increase in the rate of economic growth as the cost of

financing economic growth declines. This however may not

occur as the loss of the policy tool could lead to inflexibility

as the economy is not able to respond to shocks, resulting in

an increase in sovereign risk. This paper explores the effectof dollarization on sovereign risk in Ecuador and concludes

that dollarization does not decrease sovereign risk.

JEL Classification Codes: E44; F31; G19; O54.

Keywords: Sovereign Risk; Dollarization; Ecuador.

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Introduction:

Throughout the 20th

century, Panama remained the only country in Latin

America to use the U.S. dollar as its official currency. However, by the beginning

of the twenty-first century, the U.S. dollar status in Panama will no longer be a

peculiarity in Latin America. Following the two oil shocks of the 1970s, many

Latin American economies experienced financial distress that necessitated help

from the international financial institutions. In the early nineteen eighties, the U.S.

Treasury lead the rescue effort by helping those countries issue the so-called Brady

bonds. However, during that decade, Latin America enjoyed neither the level of

recovery that was expected, nor the economic prosperity experienced by the Asian

Tigers (Taiwan, Hong-Kong, Singapore, South Korea). Thus, in policy circles, the

eighties would be called the lost decade for Latin America.

In the early 1990s, motivated by the relative economic success of the Asian

Tigers, and convinced by policy advices coming from the U.S. Treasury, the WorldBank and the IMF (the so-called Washington Consensus), Latin America followed

the lead of Chile and embraced neo-liberal policies. This policy package included

privatization of public enterprises, removal of trade barriers, and capital account

liberalization. The brisk increased in capital flow caused by the liberalization of

financial markets and the potential for a sudden-stop constituted an element of

financial fragility that would manifest itself in the mid to late nineties.

One of the common characteristic of the crisis experienced in the second

half of the nineties in Latin America is the move of the public away from their

local currency in order to seek the protection against inflation provided by a hard

currency, the dollar. However, this process known as de-facto dollarization

posed a challenge to macroeconomic policy makers throughout Latin America. As

the demand for the local currency decreased relative to supply, the risk of its

devaluation increased and monetary policy became less effective. By the end of

the 1990s many analyst and policy makers suggested that eliminating their own

currency and adopting the U.S. dollar as legal tender would remedy Latin

Americas monetary instability and force a solution to the chronic fiscal imbalance.

Key among the promises of dollarization is the reduction of the sovereign risk

associated with developing country debts. That in turn would lead to decreased

cost of financing economic growth.In this paper we analyze the experience of Ecuador, and test the hypothesis

that official dollarization is not a determining factor in the reduction of sovereign

risk. If this is true, the implications adds another perspective to the debate on the

effects of dollarization that could be profound given the consensus from the few

studies of this relationship that there is a link between sovereign risk and economic

performance. As pointed out by Nogues and Grandes (2001), the sovereign risk is

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important because of the crucial role it plays in determining financial costs and real

business cycles. Finding out the determinants of sovereign risk and financial cost

could help to determine future policy prescriptions especially as they relate to

exchange rates and dollarization in countries like Ecuador. Furthermore, research

in this area is relatively recent with only a few economists emphasizing the

relevance of country risk on the dynamics of the economy.

In the second section we review briefly the literature on sovereign risk and

dollarization in order to provide justification for our work. In the third section we

analyze the determinants of sovereign risk. In the fourth section we present the

result of the econometric analysis. The conclusion and policy implications are

presented in the fifth section.

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II - Literature Review

In recent years research on the effect of dollarization has been conducted by

Bogetic (2000), Alesina and Barro (2001), Beckerman (2001), Edwards (2001),

Willett (2001), Edwards and Magendzo (2003), Levy-Yeyati and Sturzenegger

(2003), Jacome H (2004), and Ize and Levy-Yeyati (2005). Other papers have

looked specifically at dollarization and country risk. In a recent summary paper by

Nogues and Grandes (2001), the papers on country risk were divided into three

groups. The first group that includes Avila (1998), Grandes (1999), and Rodrguez

(1999) found a significant (negative) correlation between the large macroeconomic

aggregates and the risk premium. In the second group, Rubinstein (1999) argued

that once exchange risk disappears with dollarization, there will be a lower country

risk with higher growth and employment rate. In the third group, the relationship

between capital flows, contagion effects and the incidence on sovereign risk is

analyzed (Calvo and Reinhart, 1996; and Calvo, 1999).Other researchers have discussed dollarization in terms of its link to country

and devaluation risk. Some authors concluded that in the absence of balance sheet

effects, a full dollarization of an economy increases its country risk. However,

when balance sheet effects are present, the full dollarization could reduce country

risk. For them dollarization ultimately is a fiscal issue. In the paper by Edwards

and Magendzo (2001), although countries that dollarized were found to have lower

inflation rates than countries with a national currency, the dollarized countries

were found to have lower growth rates and higher volatility. Jacome Hs (2004)

research focused on de facto dollarization.

Although Ecuador officially adopted the U.S. dollar as its currency in March

2000, de facto dollarization was significant before 2000. De facto or unofficial

dollarization is the holding by residents of assets and liabilities denominated in a

foreign currency, in this case the U.S dollar. Ize and Levy-Yeyati (2005: 4) noted

that for example, in the first quarter of 1998, one third of on-shore deposits were

in U.S. dollars, and that by 1999 the share had increased to close to 50%. Jacome

H (2004) research concludes that unofficial dollarization in conjunction with other

factors (institutional weakness and rigidities in public finances) amplified the

financial crisis in Ecuador in the 1990s. Jacome H (2004) found that in Ecuador in

the 1990s institutional factors restricted the governments ability to prevent theescalation of the banking crisis. He also found that public finance rigidities during

dollarization limited the governments capacity to correct existing imbalances and

the deteriorating fiscal stance associated with the costs of the unofficial

dollarization. In the end Jacome H (2004) claimed that dollarization led to

increased demand for foreign currency and accelerated the currency crisis because

it reduced the effectiveness of financial safety nets.

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A summary paper on Ecuadors dollarization experience that was prepared

by Abrego, Flores, Pivovarsky, and Rother (2006) indicated that although six years

are not long enough to judge whether dollarization was right for the Ecuadorian

economy, the period can still be used to assess how well dollarization is serving the

economy. Using a regression of the Ecuador sovereign spreads on 10-Yr Treasury

and several dummy variables, including one for dollarization, they found that

dollarization do not have a significant effect on spreads. Like most of the other

research, Abrego, Flores, Pivovarsky, and Rother (2006) put forward the idea of a

trade-off between lower and stable interest rate versus the economys inflexibility

and inability to adequately respond to shocks after dollarization. However, their

analysis did not include any fiscal or domestic macroeconomic variable as a

determinant of Ecuadors sovereign spread.

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III - The Determinants of Sovereign Risk

Edwards (1986) assumes risk neutrality of lenders and describe the rate of

return on sovereign debt in an economy with high capital mobility as an arbitrage

condition:

(1-p)(1+i*+s) = 1+i

*(1)

From equation (1) p is the probability of default, i*

as the risk free rate of return on

U.S. Treasury bill, and s as the sovereign risk premium. Thus:

s = [p/(1-p)]k, (2)

with k = 1+i*

Theoretically, the risk premium approaches infinity as the probability of

default tends to one. In practice, for a given i*, the risk premium will vary with the

probability of default. However, the probability of default never gets close to one,

because the borrower would be denied access to the bond market as an increasing

probability of default signals a financial crisis.

A logistic function given in equation (3) can be used to describe p:

p = (exp iXi)/(1 + exp iXi) (3)

where Xi are the determinants of the sovereign risk premium and i are the

respective coefficients.

Combining (2) and (3) and applying natural logs, the equation becomes:

Log s = + log k + iXi (4)

As in Nogues and Grandes (2001), we follow the practice of the rating

agencies, in the measure of country risk and in the determination of the relevant Xi

variables. Ecuadors country risk is measured by the average EMBI spread of itsgovernment bonds, published by JP Morgan: Spread measures the risk premium

over US Treasury bonds. For the determining factors, we use four classes of

variables: (1) Macroeconomic fundamentals related to the possibilities of debt

repayment; (2) Contagion variables to capture the effect of instability in other

financial markets on Ecuador (3) Political variables to capture the effect of unrest

on financial market; and (4) Structural reform variables.

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By including macroeconomic variables we are extending the model used in a

recent research by Abrego, Flores, Pivovarsky, and Rother (2006). The macro

variable included in our analysis is the public external debt to GDP ratio. We use

the public external debt to GDP ratio rather than the Debt Service to Export ratio,

because it is less influenced by debt restructuring and other arrangements that may

change the repayment profile without changing the amount of debt outstanding.

The contagion variable that we use is the EMBI index for non-Latin countries. The

contagion effect of non-Latin American emerging countries is included because of

the importance of headline risk in emerging markets. We also use the 10-year U.S.

Treasury rate to capture the impact of developments in the U.S. market on

Ecuadors sovereign risk. We did not the use the 30-year rate because its issuance

was discontinued during the late nineties to the early 2000s due to the U.S. fiscal

surplus. A dummy variable is used to control for major political unrest in Ecuador

during the period of analysis. Specifically, we try to capture the effect of three

presidential overthrows (Buccaram, Mahuad, and Gutierez) during the past decadeon Ecuadors sovereign risk. Another dummy variable is used to capture the

significance of dollarization as a structural reform.

With regards to the Public External Debt to GDP ratio variable, the expected

sign of the coefficient is positive as an increase in the size of the debt increases the

probability of default hence sovereign risk increases. Because investors have a

tendency to project the developments in a particular emerging market to all

emerging markets, whether its in Latin-America or not, we expect the sign of the

contagion variable (EMBINONLAT) to be positive.

There is some ambiguity about the expected sign of the 10-year U.S.

Treasury variable. It should be positive if when U.S. interest rates are low,

investors increase their demand for emerging market debt and depress their yield

(substitution effect). However, that sign may be negative if the prospect of

financial crises make investors ignore increasing yields offered by emerging

market debt and look for the safety offered by the low yield U.S. Treasuries (flight

to quality).

The magnifying impact of political crisis on financial risk is well

documented and the sign of the political unrest dummy should be positive. The

consequence of dollarization (the variable of interest) on sovereign risk is not

straightforward. From an orthodox point of view, the official dollarization of asmall economy with chronic macroeconomic imbalance like Ecuador should

improve the financial environment. It is equivalent to the elimination of monetary

policy viewed as a source of instability, and that should improve fiscal

management. However, the economys inflexibility and the loss of a policy tool

that could be used in responding to shocks may cause an increase in sovereign risk.

Consequently, the expected sign of the dollarization dummy is ambiguous.

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The model used in the empirical analysis is summarized below with the

signs in parentheses denoting the expected effect of the variable on sovereign risk.

EMBIECU = [EMBINONLAT(+),UST10(+/-), DEBT-GDP(-), POL(+),

DOL(?)] (5)

Where,

EMBINONLAT is average spread for non-Latin countries,

UST10 is the rate of interest for 10-year U.S. Treasury bond.

DEBT-GDP is the Public External Debt over GDP ratio,

POL is a dummy for political crisis,

DOL is a dummy that identifies the official dollarization period,

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IV Econometric Estimation

In order to estimate Equation 5, we take the natural log of the variables on

both sides of the equation, with the exception of the Debt-GDP ratio and the

dummies, and we run a linear regression. Before we present the results for the

estimated equation, we provide some preliminary analysis of the dataset. Chart 1,

below, presents EMBI spread in level form (not natural log) for Ecuador,

Argentina, Brazil, Mexico, and a Non-Latin Countries average during the 1997-

2006 period.

Chart 1

EMBI Spread for Ecu, Bra, Arg, Mex, and Non-Latin Average

0

8000

7000

5000

6000EMBISpread

EMBI_ECU

EMBI_MEX

3000

4000 EMBI_ARGEMBI_BRA

EMBI_NLA

1000

2000

As with any empirical analysis, the test to determine whether the data were

normally distributed was applied to the variables (in the form that they are used in

the regression). The results are reported in Table 1 in which all five tests including

the Shapiro Wilk, Anderson Darling, and the three DAgostino tests indicated that

the normality assumption is valid for all the measures at the 5% level. Theseresults support the use of parametric statistics to investigate the research

hypothesis. The plots in Charts 2-7 also bear out the suitability of the data as

Charts 2 & 3 confirm that the normality assumption holds for the dependent

variability and Charts 4-7 indicate that the assumption of homoscedasticity or

equal variance is also relevant.

Jan-97Jul-97Jan-98Jul-98Jan-99Jul-99Jan-00Jul-00Jan-01Jul-01Jan-02Jul-02Jan-03Jul-03Jan-04Jul-04Jan-05Jul-05Jan-06Jul-06

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Table 1: Normality Tests

Test Name Test Value Probability Level Reject H0 at Alpha = 5%?

Shapiro Wilk 0.9577 0.000837 Yes

Anderson Darling 1.3093 0.002136 Yes

D'Agostino Skewness 2.5068 0.012182 Yes

D'Agostino Kurtosis 2.8313 0.004636 Yes

D'Agostino Omnibus 14.3005 0.000785 Yes

Chart 2 Chart 3

Normal Probability Plot of Residuals of EMBIECUHistogram of Residuals of LEMBIECU

0.0-0.2 0.2 0.6 1.0

Residuals of LEMBIECU

1.0

-0.6

-0.2

0.2

0.6Resid

LEMBIECU

3.01.5-1.5 0.0

Expected Normals

-3.0-0.6

50.0

37.5

25.0

12.5

Count

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Chart 4 Chart 5Residuals of LEMBIECU vs LEMBINONLAT

Residuals of LEMBIECU vs Row

140.0105.070.035.00.0

0.2

Resid

LEMBIECU

-0.2

-0.6

1.01.0

8.06.5 7.3

EMBINONLAT

5.85.0

0.60.6Resid

LEMBIECU

0.2

-0.2

-0.6

Row

Chart 6 Chart 7Residuals of LEMBIECU vs UST10 Residuals of LEMBIECU vs DEBT-GDP

1.0 1.0

6.66.46.2

LUST106.05.8

1.00.6 0.8

DEBT-GDP0.40.2

0.6ResidEMBIECU

0.6ResidEMBIECU

0.2 0.2

-0.2 -0.2

-0.6 -0.6

Table 2 shows the mean and standard deviation of the measures excludingthe dummy variables. The standard deviations confirmed the high variability of all

measures. This points to the crucial importance of contingency planning in the

financial sector in Ecuador, and could also help to explain why the move towards

dollarization occurred so rapidly: there was no emergency plan to avoid the rapid

deterioration of the Ecuadorian Sucre. Interestingly, all measures tested (except

POL and DOL) failed to reject the null hypothesis for equality of means when the

Levene test was applied to the two data subsets. We can therefore conclude that

dollarization did not affect the integrity of the sample.

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Table 2: Descriptive Statistics

Standard

Variable Count Mean Deviation Minimum Maximum

LEMBINONLAT 120 6.170475 0.7081833 5 7.72

LUST10 120 6.200265 0.1579112 5.81 6.54

DEBT-GDP 120 0.5221247 0.2091631 0.25 1

LEMBIECU 120 6.982147 0.5333222 6.19 8.39

Table 3 shows the summary of the estimated model in which the directions

and significance of the observed relationships support the research hypothesis.

Four of the five explanatory variables proved to be significant at the 5% level

(LEMBINONLAT, LUST10, DEBT-GDP, and DOL) and the remaining variable

POL, proved to be significant at the 10% level. As is indicated by the F-Statistic

(162.759) in the ANOVA section in Table 3, the overall model is identified andsignificant. Based on the Adjusted R

2of 0.87, only 13% of the variation in

sovereign debt in Ecuador is unexplained by the model.

Table 3: Estimated Model Summary

Parameter Value

Dependent Variable LEMBIECU

Number Ind. Variables 5

R2

0.8771

Adj R2

0.8717

Coefficient of Variation 0.0274

Mean Square Error 3.648157E-02

Square Root of MSE 0.1910015

Power

Independent Regression Standard T-Value Prob. of Test

Variable Coefficient b(i) Error [Sb(i)] H0:B(i)=0 Level at 5%

Intercept 8.2158 1.2727 6.455 0.0000 1.0000LEMBINONLAT 0.2991 0.0632 4.733 0.0000 0.9969

LUST10 -0.7852 0.1833 -4.284 0.0000 0.9889

DEBT-GDP 2.4021 0.2638 9.106 0.0000 1.0000

POL 0.1221 0.0733 1.666 0.0985 0.3792

DOL 0.7526 0.0558 13.483 0.0000 1.0000

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Estimated Model

LEMBIECU = 8.216 + 0.299*LEMBINONLAT - 0.785* DEBT-GDP+

2.40*LUST10 + 0.122*POL + 0.753*DOL

Analysis of Variance

Sum of Mean Prob

Source DF R2 Squares Square F-Ratio Level

Intercept 1 5560.39 5560.39

Model 5 0.8771 29.68857 5.937714 162.759 0.0000

Error 114 0.1229 4.158899 3.649E-02

Total (Adjusted) 119 1.0000 33.84747 0.2844325

From Table 3, the variable of interest (DOL) seems to have increasedsovereign risk in Ecuador. This means that official dollarization that was intended

to improve the financial environment in Ecuador did not produce by itself the

intended consequences. Looking at Chart 1, we can see a sharp drop in sovereign

spread from March 2000, when the dollarization policy is implemented, to six

months later in September 2000. However, up to four years after the official

dollarization decision, Ecuadors sovereign spread was still higher than in the pre-

crisis 97-98 period. We can blame this on what we thought earlier in this paper

that with dollarization and the loss of the monetary policy tool, Ecuador was not

able to respond to shocks in the economy. This inflexibility in the economy

resulted in an increased pressure on sovereign risk.

Of secondary importance was the interest rate variable (LUST10). This

proved to be inversely related to sovereign risk, leading us to conclude that

financial crisis in Ecuador caused investors to ignore increasing yield in Ecuador

as they looked for safer haven for their investments. This result is consistent with

that obtained by Nogues & Grandes (2001).

As expected, the contagion effect is significant and sovereign risk in

Ecuador varies directly with sovereign risk in non-Latin countries

(LEMBINONLAT). Instability in other emerging financial markets tends to

increase sovereign risk in Ecuador, due to what market professionals call headlinerisk. With regards to the Public External Debt to GDP ratio variable, the empirical

result obtained showed that sovereign risk varies directly related to the size of the

external public debt to GDP ratio.

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V. Conclusion

In 1999, four years after implementing its Real Plan, Brazil devalued its

currency and readjusted its exchange rate relative to the U.S. dollar in order to

stabilize the economy. In March 2000, in the midst of a political and economic

crisis, Ecuador removed its national currency, the Sucre, from circulation and

adopted the U.S. dollar as legal tender. In the fourth quarter of 2001, eighteen

months after Ecuador has officially dollarized, Argentinas currency board

collapsed. At that time, official dollarization was considered on the menu of policy

prescriptions for Argentina. However, by 2002, Argentinas government opted for

a policy mix consisting of asset freeze and currency devaluation. Due to that

financial crisis, Argentina experienced high levels of EMBI spread for four years.

Curiously, it is the same amount of time it took for Ecuadors sovereign spread to

return to pre-crisis level. Moreover, during the last two years in our sample (2005-

2007) Ecuadors Sovereign spread has been higher than those of Argentina, Braziland Mexico, a situation that resemble the first two years in the study period (96-

97). These observations support the view that even though official dollarization

may be appealing to policy-makers in the middle of a currency crisis, ultimately

sovereign risk is function of the soundness of the governments fiscal position and

is not a function of the currency regime.

Since Ecuador officially dollarized in March 2000, no country in South-

America has followed what some expected to be the trend during the first decade

of the twenty-first century. Since 2005, Argentina, an important member of

Mercosur with strong ties to Brazil, definitely emerged from the Tango crisis.

Moreover, the more fragile economies of the Andean region like Colombia, Peru,

and Bolivia, believed to be the prime candidates for official dollarization during

the nineties, managed to maintain a certain level of economic performance and

preserved their national currencies in the presence of de-facto dollarization. If in

policy-making circles official dollarization is no longer viewed as a panacea, future

academic research on the determinants of the dollarization decision and its

consequences on economic growth and the distribution of wealth should find more

attentive ears.

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