Dollarization and Debt: Theoretical insights and lessons from the case of Ecuador John Cajas Guijarro

Full dollarization, a term which describes a situation where a foreign currency becomes the sole legal tender within an economy, is often viewed as a remedy for countries in the throes of high inflation or currency devaluation. However, fully dollarized economies are uncommon, and there is no consensus in the economic literature about its effects, often due to biases in empirical studies on the subject (Kórab et al., 2023).

There are two contrasting theoretical views on the linkages between dollarization and external debt. On one hand, dollarization may incentivize fiscal discipline due to the severe costs associated with debt defaults. This restraint could enhance international financial markets confidence in dollarized economies, facilitating access to external debt at favorable interest rates (Arellano and Heathcote, 2010). Conversely, under conditions characterized by a strong preference for cash (physical currency) and heavy reliance on cash in payment chains, dollarization could lead to structural dependency on ever increasing levels of external debt. This scenario can lead to pronounced pressures on the current account and increases the likelihood of debt crises and defaults, particularly when the dollarized economy faces external adverse shocks (Acosta and Cajas Guijarro, 2018; Missaglia, 2021).

Given the lack of consensus in the economic literature, the case of Ecuador offers useful insights. Dollarization in Ecuador emerged from a severe banking crisis in 1998-1999, prompting official adoption of the US dollar as legal tender on September 9, 2000. While this stabilized inflation, the positive impact of dollarization on other aspects of the economy was limited. Until 2014, Ecuador’s GDP growth rates remained similar to pre-dollarization levels. After a decline in oil prices in 2015-2016, per capita GDP stagnated until 2019, before collapsing in 2020 due to the COVID-19 pandemic. In order to stabilize the economy, governments increased sovereign debt. However, these attempts proved ineffective, resulting in periods of debt crisis, economic stagnation, and worsening labor market conditions.

The initial years of dollarization saw a notable reduction in Ecuador’s external and internal sovereign debt. However, this trend was reversed in the aftermath of the 2009 global financial crisis. External debt stabilized around 12.6% of GDP between 2009-2013 but surged after 2014, reaching 45.9% of GDP in 2020 before slightly stabilizing at 41.7% of GDP in 2022. Internal debt, on the other hand, stood at 4.5% of GDP in 2009, but grew significantly over the years, reaching 24.3% of GDP in 2021 before stabilizing at 23.3% of GDP in 2022. This rise in Ecuador’s debt-to-GDP ratios coincided with periods of debt crises and increasing country risk premiums, indicating that dollarization does not guarantee debt stabilization.

The recent history of Ecuadorian sovereign debt during dollarization is also illustrative. While Ecuador managed to decrease its sovereign debt-to-GDP ratios between 2000-2008, the global 2008-2009 financial crisis forced the Correa government to suspend interest payments on several bonds, leading to a debt servicing renegotiation process that resulted in significant reductions in external debt service from 2007 to 2010. However, this renegotiation process engendered negative reactions in international financial markets, leading to increased country risk premiums and IMF suspension.

Subsequently, Ecuador relied on new credit suppliers like China and internal debt to finance its expansive fiscal policy initially implemented in response to the global financial crisis and later to sustain economic growth. These stabilization efforts were disrupted by oil price declines in 2015-2016. In response, Ecuador increased sovereign debt at a rate faster than that of economic growth from 2015-2019 without successfully overcoming economic stagnation.

After renewing ties with the IMF in 2019, the country faced severe disruptions due to the COVID-19 pandemic. The pandemic inflicted an extreme negative shock, sharply increasing fiscal pressures. In April 2020, the Ecuadorian government declared default and in May 2020 the IMF agreement was suspended pending renegotiation. Meanwhile, the local economy experienced disruptions in its payment chains. By August 2020, sovereign debt renegotiations were completed. Subsequently, in September 2020, the Ecuadorian government reached a new agreement with the IMF and secured ‘fresh resources’ from external debt, partially restoring payment chains.

The default on Ecuadorian sovereign debt in 2020 highlights the heavy reliance of the dollarized economy on external debt. Despite efforts to stabilize the Ecuadorian economy, debt servicing issues persist. From 2024 onwards, Ecuador faces the obligation to fulfill the maturity payments for bonds negotiated in 2014. In addition, in 2026, the country must commence payments on bonds renegotiated in 2020. As a result, the Moreno government intensified the pace of structural reforms at the beginning of 2024 with the aim of securing a new financial agreement with the IMF, recognizing that failure to do so could result in further disruptions to payment chains.

Drawing from these insights, some policy recommendations emerge. Firstly, it is essential to assert that there is no one-size-fits-all monetary regime suitable for all countries. Rather, the suitability of a monetary regime should be evaluated based on the concrete needs of each society and through rigorous technical studies tailored to the specific circumstances of each economy should precede the implementation of monetary regimes like dollarization.

Secondly, instead of focusing on severe adjustments and labor market deterioration to compensate for the absence of nominal exchange rate flexibility, discussions should focus on introducing monetary flexibility. For instance, in the case of Ecuador, options include the use of alternative means of payment, such as electronic currency administered by the central bank. This could be coupled with economic incentives to reduce preference for cash and create instruments to implement countercyclical fiscal policy.

Thirdly, there is a need for a deeper examination of the roles of the central and private banks in influencing money creation. Dollarization exemplifies a scheme where the central bank loses influence while the private banking sector enjoys full freedom to extend loans and create deposits, legally recognized as equivalent to the anchor currency. Discussions around decentralizing and nationalizing the banking system are valuable in this context.

Lastly, discussions should explore the implementation of alternative international monetary schemes less reliant on the U.S. dollar rather than relying on global financial markets and institutions like the IMF or the World Bank to address external shocks. In this regard, the consolidation of economic blocs facilitating trade and financial transactions from a de-dollarization perspective offers a promising alternative. However, such a proposal requires a broader discussion on the international financial institutional architecture.

** This article builds on the analysis and research produced for the IDEAs Conference on the African Debt Crisis and the International Financial Architecture

John Cajas Guijarro : Doctor in Development Economics (FLACSO-Ecuador). Professor at the Central University of Ecuador (School of Economic Sciences). Personal site: https://sites.google.com/view/johncajasguijarro