Banking on the Greenback

Guatemala is adopting the United States dollar next month as its national currency in all but name, relegating its battered quetzal to almost certain oblivion. The Law of Free Negotiation of Foreign Exchange, which comes into force in May, allows any foreign currency to be used in Guatemalan business transactions. However, officials say the only currency Guatemalans are likely to want to use is the greenback. “It is the reverse of Gresham’s Law,” says Lizardo Sosa, president of Guatemala’s Central Bank, “in which good money drives out the bad.”

In fact, the quetzal has maintained its value reasonably well as the government of President Alfonso Portillo has struggled to press ahead with strict fiscal and monetary policies and started cleaning up the financial system (see Guatemala survey). Embracing the dollar is intended to buttress these reforms.

Neighboring El Salvador went a step further in January, scrapping its colón altogether. Unlike previous experiments with dollarization in Latin America, these countries chose to give up their national currencies, instead of being forced to embrace the dollar by events. In January 2000, Ecuador dumped its currency, the sucre, in favor of the dollar to avert economic disintegration. A decade earlier, Argentina pegged its peso to the dollar by law to stamp out hyperinflation.

A Central Feature
Rafael Barraza, president of El Salvador’s Central Bank, points out that over the years the dollar has become a central feature of the region’s economies, particularly in his country. “The dollar is not new to the region. The reality is that over half of Central America’s exports go the US and a quarter of the region’s exports going to Latin America are denominated in dollars.” Salvadorian workers in the US send about $1.75 billion, or 13% of GDP, home every year.

El Salvador also has the region’s most robust economy. “El Salvador adopted the US currency from a position of strength,” says Barraza. Adopting the dollar was “an important complementary measure to El Salvador’s macroeconomic achievements.” The government is using the dollar to anchor these reforms. Business leaders say this would also prevent any future policy reversals should the left wing opposition FMLN party win presidential elections in 2004.

The country has undergone wholesale privatization, eliminated capital controls and brought inflation down to 2.5% in 2000. Economic growth averaged 5% per year since the end of civil war in 1992, although expansion slowed in 1999 to 2.5%. The US takes 60% of El Salvador’s exports. Officials say the economy should grow 3% this year, even after two devastating earthquakes in January that killed thousands and caused damage estimated at $2 billion.

Guillermo Calvo, the newly-appointed chief economist at the Inter-American Development Bank, argues that “El Salvador’s pivotal position as the largest and most stable economy in the region and the biggest trading partner of other Central American countries is a big incentive for those nations to dollarize.”

Not everyone agrees, though. “Technically it may make sense for small countries like us to dollarize,” says Gabriela Núñez de Reyes, minister of finance of Honduras. But she recognizes that the country has a lot of work to before dollarizing: “It requires many changes to our institutions and cultural changes for our people.”

El Salvador’s Case
Calvo notes that interest rates collapsed after El Salvador dollarized. “Although the colón was fixed at 8.75 to the dollar since 1993, borrowers were still paying about three [percentage points] more in real interest rates because of the perceived exchange rate risk,” says Calvo.

Manuel Hinds, El Salvador’s finance minister between 1995 and 1999, says switching to the dollar boosted demand for housing as mortgages became affordable when interest rates came down to 11% from 14% and maturities on bank loans extended from five years to 20 to 30 years.

Dollarization is reducing margins and increasing competition in the banking industry. Banks cannot charge commission on currency exchanges, local treasury investment revenues have fallen 7% and loan portfolio revenues have dropped 14%. The cost of deposits has risen by 27%. Even so, dollarization is probably good for local banks. Funding in dollars brings greater balance sheet stability, creates cross-border opportunities and protects banks’ equity against devaluation. The government has compensated banks for this by paying interest on reserve requirements.

A solid financial system should help El Salvador cope with reconstruction after the earthquake. “It would be impossible to reconstruct the country with interest rates of 22%,” says Barraza. The government expects to finance reconstruction with $1.4 billion in aid pledged by the World Bank, the European Union and the US.

Now that dollarization has eliminated currency risk, one senior banker says the country needs to ensure sustainable growth by deepening structural reforms and revising the labor code to attract foreign investment, which has flagged in recent years. He says: “El Salvador needs jobs, jobs, jobs.” He says the entire machinery of state, especially the judiciary, also needs to be revamped to increase investor confidence. It must also cut high crime levels that have discouraged foreign investment.

Dollarization does imply considerable costs and compromises. The central bank’s ability to act as lender of last resort is limited because it can no longer expand liquidity at will. Officials hope increasing foreign ownership of the banking system will bring an implicit guarantee that banks’ home country regulators would require them to support subsidiaries that got into trouble.

Building up large reserves should help regulators deal with a banking crisis. The central bank maintains 35% of its reserves in cash and requires local banks to maintain reserve requirements equivalent to 22.5% of deposits. “El Salvador’s reserve requirements are much higher than is normally the case,” says Hinds, “but we wanted to have a good buffer.” El Salvador is also considering establishing contingency lines, such as the $6 billion Argentina arranged in standby loans with a group of six international commercial banks.

Giving up the right to issue currency deprives governments of seignorage, the revenue central banks receive for creating money. El Salvador’s central bank lost 0.2% from seignorage, a considerable sum. Draft legislation languishing in the US Congress would share dollar seignorage with countries converting to the dollar on terms acceptable to the US Treasury.

Currency Board Straitjacket
The greatest risk is that El Salvador could rapidly find itself in Argentina’s unenviable position, were its economy to stall. In 1991, Argentina’s currency board regime snuffed out hyperinflation and initially delivered strong growth. But progress on reform petered out in the mid-1990s and the country sank into recession nearly three years ago.

The currency board became a straitjacket: foreign investment fell and exporters are struggling. In December only a $39.7 billion international package put together by the International Monetary Fund averted a payments crisis. Domingo Cavallo, the new economy minister, is fighting to restore growth. Aides to Cavallo say he wants to abandon the dollar peg for a basket of currencies that reflect Argentina’s external trade.

If he fails, Argentina may have to adopt the dollar as its sole currency. The alternative – devaluation – would probably lead to default on the country’s entire $123.7 billion foreign debt.

Ecuador may also be courting disaster. It adopted the dollar in 2000 in a partially successful attempt to revive its economy. These efforts may be doomed unless the government of Gustavo Noboa wins congressional support for further structural reforms. His predecessor Jamil Mahuad was toppled in a coup in January 2000. By the time Noboa had abandoned the sucre for the dollar shortly after, the currency had plunged 64% and billions of dollars left the banking system.

A Confidence Shock
Switching to the dollar when the economy was spinning out of control provided a confidence shock that halted the outflow of bank deposits, says John Chambers, deputy head of sovereign ratings for Standard&Poor’s. Ecuador, however, is still trying to control the inflation caused by the government’s decision to convert sucres to dollars at a very depreciated rate, says Guillermo Perry, the World Bank’s chief Latin America economist. Inflation should fall to 20% or 30% this year, down from 91% in 2000.

At least the banking system is under control, deposits are returning to the banks and the government is running a fiscal deficit of 4% to 4.5%, in line with targets set out by the IMF. “The year 2000 was a year of transition,” says José Luis Ycaza, president of Ecuador’s central bank. “We are now beginning to see the benefits of dollarization in lower inflation and lower prices,” he says. Ycaza says the economy is growing again and external debt-to-GDP ratio should drop to 67% this year from 81% in 2000. Last year, Ecuador exchanged $6.46 billion in defaulted Brady and Eurobonds for $3.95 billion in fresh bonds in an operation led by Salomon Smith Barney and JP Morgan.

Ycaza says the government is overhauling the economy to ensure that dollarization will work. Since Ecuador can no longer devalue, it must increase the efficiency of its economy. The three-stage economic modernization law, known as the Trolleybus Law, includes restructuring a further $11.47 billion in international debt, laying the groundwork for privatization of state assets and reforming the tax system to increase revenues.

This is no easy task. The government faces bitter opposition in Congress and protests on the streets, which have already forced it to back-pedal on unpopular reforms such as cutting cooking gas subsidies. One banker says, “Congress is being short-sighted about the benefits of painful short-term measures such as tax increases.”

Noboa scrapped a 1% financial transactions tax and an import tariff surcharge in January, eliminating revenues equivalent to 2.5% of GDP. Raising VAT may be unpopular but is crucial to convince the Fund that the government is committed to reform. “The government must show that it can take tough decisions and see them through,” says the banker, “otherwise the $150 million disbursement from the IMF, some $350 million in multilateral loans and a restructuring of the Paris Club debt could be in jeopardy.”

Jorge Gallardo, the Ecuadorian finance minister, says, “With the approach of the elections [in October 2002], it is important to have political stability. Nothing will happen to damage stability.” The government needs to placate Indian groups, which oppose dollarization and helped topple Mahuad in 2000, to keep the reform process on track. The Central Bank’s Ycaza says: “If dollarization translates into cheaper goods and more jobs and it helps more of Ecuador’s people, it will be easier to pass reforms.”

Building a Buffer
Ecuador is starting to reform its banking sector and recognizes the importance of building up a buffer of dollar reserves to protect against future crises, says Ycaza. He says the government is working on improving regulation of Ecuador’s banks and has awarded contracts to two Spanish banks to take over management of Ecuador’s two largest banks – Banco Pacífico and Filanbanco.

Gallardo says a $180 million liquidity fund to replace the Central Bank as lender of last resort is in place. Banks must contribute 1% of deposits, or $34 million, and the Corporación Andina de Fomento (CAF), the regional development bank, is contributing $146 million. Gallardo says the government is also creating a stabilization fund using export revenues from a new oil pipeline.

Still, dollarization is a high-risk strategy. It requires a commitment to stringent fiscal policies and an open, highly competitive economy. A dollarized economy needs a consistent flow of dollars either through trade, remittances or direct foreign investment, says Luis Murillo, professor of international business and global management at the University of San Francisco.

Reversing dollarization is almost impossible under normal conditions. It probably could only happen amid severe economic dislocation and a debt crisis. “There hasn’t been a case to date of [a country] abandoning the dollar. It would be very difficult to make people accept a weaker currency when they have a stronger one in their pocket,” says S&P’s Chambers. Ecuador’s Ycaza agrees, “It would be impossible. The people would not accept a weaker currency.” LF

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