Dollarization In Ecuador

25 oranges Liquefied Gas

20 333 sucre 25 000 sucre

$0.81 (dollars) $ 1 dollar

Introduction.

F

or the past century there have been radical changes in economic philosophy, resulting in a debate over which exchange rate is best in a world of high capital mobility and capital flows. This debate has produced revolutionary and innovative answers to the question and with it, substantial sources of disagreement among exchange rate economists. Many economists now recommend that countries give up the idea of intermediate exchange rate models and adopt corner solutions such as free floating exchange rates, and currency boards or dollarization. The latter has become highly popular among emerging economies, principally in Latin America, despite its controversiality.

In the first section of my essay I am going to talk about some of the theory behind the exchange rate and from there decide what is the best choice for EM economies. In the second part, I will analyze some empirical evidence related to currency board and dollarization. In the last and third section of this paper I try to answer the question when is dollarization necessary despite its uncertainty?

1. Which exchange rate is best for EM economies.

According to Robert A. Mundell (1960, 1961) "The argument for flexible exchange rates based on national currencies...[works as long as the]...factor [labor and capital] mobility is high internally and low internationally...The flexible exchange system works badly if capital mobility is mobile because the rate of interest has a more direct effect on the balance of payments than on the market to which responds (the goods-and-services market)". Nowadays, with a globalized world economy with free trade agreements such as NAFTA, CAFTA, MERCOSUR, and regionalized economic unions such as the EU and soon the FTAA, there are no doubts that the degree of capital mobility has become and will only get higher.

Given a globalized world economy, I strongly believe, a flexible exchange rate system is inadequate for small and less diversified emerging market (EM) economies since they are more vulnerable to shocks with respect to more diversified economies. For example, if countries in a region actively participate in the production of an specific final good through the assembly of parts, any shock in the aggregate demand of this good will result in a shock that will affect all economies that participate in the production of this good. Additionally, if these countries' industries are not very diverse, a small shock will be likely to have a greater effect and remain longer than it would have. Furthermore, EM economies with flexible exchange systems have seen that when shocks occur, the exchange rate system is not able to foresee the incoming crisis as it is expected, and often it worsens the situation before it gets any better (Calvo and Reinhart 2000). Consequently, in agreement with "The Theory of Optimum Currency Areas" (OCA) (Mundell 1961) and because of the high degree of capital mobility combined with a high scale of capital flows, which has been seen to cause high volatility in the exchange rate markets, a flexible exchange rate is undesirable for small and less diversified EM economies. Nevertheless, if these countries find the willingness to devote their energy and resources to low inflation rates and a more credible and stable exchange systems that will facilitate trade which will take them to a faster economic growth path, then the debate suggests adopting "hard-peg" systems such as a currency board or even to dollarization.

The differences between a currency board and dollarization are minimal. A currency board issues local notes and coins that are generally anchored to a more powerful, stable, tradable international currency such as the British pound, American dollar, or Euro. Consequently, the national currency depends on the stability of the foreign pegged-currency, thus resulting in a strictly fixed exchange system. Under a currency board system the country's monetary policy is determined by supply and demand and not by its central bank policies. The currency board then is unable to adjust the interest rate by setting up a discount rate and it cannot serve as a lender of last resource for the banking system nor for the government. Therefore, the system itself generates awareness about risky businesses among bankers and eliminates the inflationary temptations of the government to print money. As a consequence, it obligates the economy [government] to become more efficient in collecting taxes and more conscious about borrowing since these two are its only mechanism for generating revenues. Moreover, the interest rate for countries with the currency board ends up being very similar to that of the pegged-currency, with a degree of difference that counts for the risk of investing in that country. On the other hand, dollarization is a rigorous irreversible state that brings an exceptional level of credibility to the market. However, this credibility comes at the cost of the loss of government's revenues from seigniorage.

2. Currency Board and Dollarization.

Even though a currency board adds a number of preventative features for possible monetary crisis in the market it has not been "...immune to costly speculative attacks" (Berg and Borensztein 2003). Argentina, for example, recently went through a painful crisis that left millions of Argentineans in extreme poverty.

Date of

measurement Extreme

poverty Under

poverty

line

May 2001 11.6% 35.9%

Oct 2001 13.6% 38.3%

May 2002 24.8% 53.0%

Oct 2002 27.5% 57.5%

May 2003 26.3% 54.7%

2nd sem 2003 20.5% 47.8%

1st sem 2004 17.0% 44.3%

2nd sem 2004 15.0% 40.2%

1st sem 2005 13.6% 38.5%

Poverty