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Will Ecuador Say Adios to the Dollar?

Article Summary:

Since 2000, Ecuador has been using the U.S. dollar as its national currency. The move has been credited with saving the economy from the brink of collapse – but trouble might be on the horizon, and investors would do well to pay close attention to a little-noticed battle that this small Andean country of 14.7 million has been fighting: keeping its dollar-based economy intact.

Photo Credit: Financial Time

Original Article Text From Financial Times:

Ecuador: Time to say Adios to the Dollar?

Ecuador’s tussle with the UK over the fate of WikiLeaks founder Julian Assange might be dominating the headlines these days.

But investors would do well to pay closer attention to another battle that this small Andean country of 14.7m has been fighting: keeping its dollar-based economy intact.

Since 2000, Ecuador has been using the US dollar as its national currency. The move has been credited with saving the economy from the brink of collapse – reviving the insolvent banking system and reining in hyperinflation – which at the time was running close to 100 per cent.

Yet faced with falling oil prices – the price of Brent crude fell close to $90 a barrel in June but has since risen back to $112 – and a ballooning current account deficit, there are signs that Ecuador’s 12-year experiment with dollarisation could be coming to a crossroads.

As Stuart Culverhouse, chief economist at Exotix pointed out, the sustainability of Ecuador’s dollarisation depends on the country having enough dollars on hand to finance government expenditure.

“For dollarisation to work, you need policies that encourage inflows of dollars through exports and foreign investment because the central bank cannot print money,” he told beyondbrics.

And herein lies the potentially irksome problem.

While Ecuador’s headline GDP figures – 7.8 per cent growth last year and 4.8 per cent this year – appear to paint the economy in rude health, a failure to diversify the economy from its dependence on oil exports and remittances during the boom years means the country is now more vulnerable to a period of weaker oil prices. Ecuador produces around 500,000 barrels of crude oil a day and is Opec’s smallest member. Oil exports at $14bn and remittances at $2.7bn accounted for nearly 75 per cent of the country’s external revenues and a quarter of the country’s $67bn GDP last year.

Matters have not helped by the lack of interest from foreign investors after the country defaulted on $3.2bn of global bonds in 2008 and 2009. Foreign direct investment into Ecuador totalled just $386m last year, the lowest in South America after Paraguay.

Michael Henderson of Capital Economics has this to say [emphasis ours]:
…the need for a well-managed fiscal policy is of vital importance in a dollarised economy. This is because policymakers cannot devalue the currency and/or loosen monetary policy to stimulate growth. Suffice to say, the fact that Ecuador has been running sizeable budget deficits during a period of rising oil prices leaves the government will little or no legroom in an environment of falling oil prices.

Another potentially worrying sign is the recent imposition of import controls to stem a growing non-oil deficit. Based on the region’s past experience, this could be a symptom that dollars are starting to become scarce and, in the extreme, may be a precursor to a balance of payments crisis further down the line.

In this context, a little-noticed announcement made earlier last month by the central bank to boost dollar liquidity in the country probably deserves closer scrutiny. Among the measures, local banks are now required to hold 60 per cent of their assets and investments in Ecuador – up from 45 per cent before. Additionally, the central bank has ordered private banks to increase its contributions to Ecuador’s liquidity fund from 3 per cent to 5 per cent until September and 1 per cent annually to reach 10 per cent.

“The government is essentially forcing banks to bring assets back,” Richard Francis, analyst at Standard & Poor’s said. “Ecuador has been trying to bring in all the money that local banks have abroad into the country to increase liquidity.”

Francis, who recently upgraded Ecuador’s long-term sovereign rating to B from B-minus in early June, believes the measures are pre-emptive rather than reactive.

“I don’t think the country is suffering from a liquidity crisis,” he told beyondbrics, adding that debt-to-GDP ratio remains in the low 20 per cent.

The view is echoed by Santiago Arias, senior analyst at PineBridge Investments, who told beyondbrics: “I think that the fight against the control of liquidity from private banks is what annoys the government, and not so much the management of current account. Next year is an election year and the government wants growth, so that is driving these decisions much more than the risk of a liquidity crisis.”

Having China on its side haven’t hurt either. With the Opec nation largely cut off from international borrowing, it has met much of its funding needs with bilateral credit deals, mostly from China.

China has now lent an estimated $7.25bn to Ecuador – 16 per cent of GDP – some of which is tied to oil exports.

That said, the fact that the new dollar measures come barely one month after Ecuador tapped the Bogotá-based regional lender, Latin American Reserve Fund, for a $514.6m loan to help finance its balance of payments, does raise questions over whether country’s dollar-based economy is feeling the strain.

In his upgrade of Ecuador, S&P’s Francis cautioned that international reserves cover just over a month of current account payments: “the ratings could come under pressure if prospects for the oil sector deteriorate significantly or the political environment worsens, leading to instability”

For all his anti-American views, analysts believes President Rafael Correa is unlikely to abandon the dollar anytime soon – namely because the alternative – returning to the sucre – would be politically unpalatable.

“What Ecuador needs to do now is to have fiscal policies – opening up for more investment and less protectionism – to build a more robust local economy that will support dollarisation,” said Culverhouse.

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