Living With the Dollar

Two cataclysmic events took place in Ecuador at the turn of the millennium: debt default, and dollarization. The first was the result of the economic and financial chaos that swept the country in the late 1990s; the second was the proposed solution. Both will have a lasting effect on Ecuador’s growth.

The events that led up to devaluation at the end of 1999 were part bad luck, part mismanagement. Ecuador’s border dispute with Peru, which flared up in 1995, the slump in the global price of oil and the ravages of the el Niño weather phenomenon had an accumulative effect on public finances. At the same time a crisis in the banking sector – fueled partly by irregular loans by the banks to companies controlled by their own shareholders – was subverting monetary policy to the needs of the financial sector: the government was printing money to keep the banks afloat.

Default Shocked Markets …
By September 1999, government spending was in such disarray that default became inevitable. “Given the amount of debt, it was impossible for them to service it,” says Luis Oganes, economist for the Andean region at J P Morgan in New York. The international financial markets were, nevertheless, shocked when Ecuador decided to halt payments on its Brady bonds, the renegotiated bonds issued after the Latin American debt crisis in the late 1980s and named after Nicholas Brady, a US Treasury secretary who helped restructure the debt of several countries in the region. It was not only that this was the first – and so far only – default on these bonds, which are backed by US Treasury bonds and were hitherto seen in financial markets as being rock solid. Investors were also alarmed that Ecuador elected to default on Brady payments while continuing to honor other bonds not backed by US Treasuries, going against the prevailing doctrine that there should be no privileged asset class.

This doctrine was further undermined as negotiations with creditors progressed during 2000. “We were not particularly happy with the outcome,” says Marc Helie, managing director of Gramercy Advisors in Greenwich, Connecticut, who invested in Ecuadorian Brady bonds after the default when he felt markets had overreacted, driving prices extremely low. What upset Helie and other foreign investors was that they ended up taking a haircut on the bonds after Ecuador effectively created a senior and a subordinate bond.

… and Left Investors Unimpressed
“The foreign bond holders were the only ones to take a haircut,” Helie says. “Everyone else – the locals, the multilaterals, the Paris Club lenders – had their schedules reprogrammed. What the foreign creditors wanted was pari passu, and they would continue to want that in future deals.”

According to Oganes at J P Morgan, “the Ecuadorians were extremely clever” during the default negotiations. While fundamental aspects of the Brady bonds, such as coupons, tenors, and so on, could only be changed with the consent of 100% of bond holders, other factors, such as those relating to cross-default and cross-acceleration, could be altered with the support of just 25%. They persuaded enough bond holders to vote to change the terms of the Brady bonds as they swapped them for new paper, leaving the remaining bond holders with little choice but to accept the new paper or stick with the original bonds, incorporating changes to which they had not consented.

“We wanted to negotiate in good faith,” says Helie at Gramercy Advisors. “They decided to abruptly end the negotiations and present us with a take it or leave it deal.”

Another aspect that bothered investors was the strong impression at the time that it happened with the tacit support of the IMF. It was even suggested – though the IMF strongly denied it – that Ecuador would have a better chance of gaining IMF funding if it defaulted on its Brady bonds. The default took place at a time when the IMF was promoting the idea of burden sharing among private investors, and was keen to “bail in” foreign lenders to any rescue deal.

“The IMF did seem to be on board with the decision to default,” says Oganes at J P Morgan. “Ecuador was a test case. It was seen as a small country that wouldn’t cause major contagion.”

Certainly the Ecuadorian default didn’t cause the kind of shock waves generated by the Russian debt default a year earlier. But it did contribute to the risk aversion that has plagued Latin American borrowers in the past few years. For Ecuadorians, the debt restructuring resulted in a reduction in total foreign debt of 39% according to the Central Bank; it also meant the end of access to international capital markets for the foreseeable future.

That means that, for now, Ecuador is dependent on the IMF and other multilateral agencies for external credit. By April, the government hopes to sign a second annual standby agreement with the IMF, expected to be worth about $300 million, which would open the way to perhaps twice that amount in additional funding from other multilaterals. Whether that will be enough to balance the government’s budget is a moot point. The government’s budgetary predictions for 2002 are based on an oil price of $19 a barrel. If, as seems likely, the average for the year falls below that level, the government will have to find cuts in capital spending.

Living With the Dollar
But it is not only default that is forcing the government to tighten its purse strings. Dollarization, by taking monetary policy out of the government’s hands, means it can no longer use devaluation to help balance its books. As Jeffrey Franks, the IMF representative in Quito, points out: “When a country decides it will no longer have control of monetary policy, that means its fiscal policy is determined by its access to capital markets.”

For some in Ecuador, relinquishing control of monetary policy was a craven admission of irresponsibility. “It’s like a rapist deciding to castrate himself,” says Fernando Bustamante, professor of government at San Francisco University, Quito. For others, that was the beauty of dollarization. As Cristóbal Orrantia, a businessman from the port city of Guayaquil, comments: “Uncle Sam now controls our monetary policy. We’ve shown for decades that we can’t do it. Uncle Sam can.”

The pitfalls of dollarization are well-rehearsed – although resistance to it within Ecuador before its announcement in January 2000 was generally based more on patriotic than on practical grounds. Among those who voiced theoretical reservations was the IMF. Its arguments would be familiar to anyone who followed the process of monetary union in Europe: that for a monetary union between countries to be successful, those countries must be open to similar shocks and have recourse to similar responses; their economies should be converging so that they can respond to those shocks without having to employ different monetary policies. They also need flexible labor and capital markets to allow them to respond to differences in their inflation rates, and they need responsible fiscal policies. Applying such arguments to dollarization in Ecuador, it was clear that Ecuador did not meet any of the basic requirements.

But as Panama and El Salvador have shown, there are circumstances in which such arguments become less relevant. In Ecuador’s case, the advantages of dollarization – some of them unexpected even among its advocates – have so far easily outweighed its disadvantages. “In retrospect,” says Jeffrey Franks at the IMF, “what we missed was the collosal confidence effect. Dollarization itself is a tool.”

A New-Found Confidence
Despite the somewhat chaotic way in which it was introduced (see box on page 14), the impact of dollarization on confidence was immediate and lasting. The legal framework needed to abandon the sucre and take up the dollar was months in preparation, yet bank deposits stabilised overnight after the announcmenet and have been growing ever since. The political background could scarcely have been less stable, yet Ecuadorians clearly believed – or very much wanted to believe – that the runaway devaluation of late 1999 was over, and that the dollar was there to stay.

“There had been no confidence whatsoever in the local currency,” says Orrantia. “The greatest thing dollarization did was to eliminate this element of uncertainty. Whatever the government does, the economy will keep going.”

If that sounds overly optimistic, dollarization should provide the government with a breathing space to see through the fundamental reforms that are necessary for sustained growth. With bank deposits on the increase, more funds are available for investment in productivity gains to offset the negative effects of dollarization on the competitiveness of Ecuardorian exports. Other factors will extend that breathing space, such as increased oil revenues from the new pipeline, and the steady flow of remittances from Ecuadorians living abroad, set to rise to $1.5 billion this year from $1.4 billion in 2001. With this kind of cushion, the worry might be that the government – especially given that 2002 is an election year – will be tempted to relax. But many in power recognize that what Ecuador needs now above all is discipline.