Ecuador Opts for the Dollar

Ecuador's central bank approved a plan late Monday to replace the local currency with the U.S. dollar. The adoption was the latest in a series of desperate measures by President Jamil Mahuad to save his political life by staving off a free fall in the economy. But it's seen by most outside observers as a stopgap measure that will only prolong the pain of Ecuadorians, many of whom have taken to the streets to call for his ouster.

Even current and former members of Mahuad's government question the actions. Monday's midnight dollarization was extracted from the central bank under threat of dismissal after Mahuad threatened to call a special session of congress to fire any banker who opposed the plan. Central bank President Pablo Better, who voiced opposition to the measure, tendered his resignation before the meeting. On Sunday, Mahuad "accepted the resignation" of his entire 15-member cabinet.

In the first stage of dollarization, Ecuador will fix the exchange rate at 25,000 sucres to the dollar. Following that, sucres will be withdrawn from circulation and replaced with greenbacks. The entire process is expected to take a year -- if Mahuad and his tactics can survive that long. To effectively dollarize, notes J.P. Morgan global economic analysis Director Phil Suttle, "You obviously need to have a reasonably sound banking system and a reasonably sound fiscal position." Ecuador has neither.

The country suffered greatly over the past year. The economy contracted more than 7% and inflation rose to more than 60%, the highest in the region. Last October, Ecuador gained the dubious distinction of becoming the first to default on Brady bonds. It was an action that not only soured investors on Ecuador, but made investors less sure of the supposedly risk-free Bradies.

Now, the president is vowing he will turn around Ecuador's economy. "I recognize that I have been slow to act," Mahuad said in a televised speech. "But I have my foot on the accelerator now."

Observers and Ecuadorians agree that Mahuad is speeding along -- toward economic ruin, not recovery. While the adoption of the dollar could stem raging inflation, it is not a cure for the deep economic troubles that face a country in the midst of its greatest economic crisis since the Great Depression. Moreover, Mahuad's government is likely to remain weakened and vulnerable.

Liquid reserves are insufficient to cover the monetary base. According to Chase Securities, foreign exchange reserves are at only $1.25 billion -- which would imply an exchange rate of 29,000 sucres to the dollar to cover the base -- and much of those reserves are illiquid.

Add to that the lack of International Monetary Fund participation in the dollarization discussions (though outgoing Managing Director Michel Camdessus said the fund would send a fact-finding mission to Quito, the capital, to discuss the proposal). Some analysts believe multilateral support is necessary for successful dollarization and a return to stability. Therefore, the short-term peg is unrealistic, and to bring more dollars in the economy soon would require unpopular reforms.

Already, the Confederation of Indigenous Nationalities of Ecuador, which represents the more than 3 million Indians in Ecuador, plans a protest on Saturday to demand Mahuad's resignation. Last week's developments were punctuated by transportation union strikes, school closures, a state of emergency and rumors of a military coup.

With no political consensus -- except under threat of dismissal -- a weak banking system, and little popular support for the president, Mahuad's belief in his ability to overcome this week's downward spiral appears little more than a temporary delusion on his part. The sooner he exits the political stage, the sooner Ecuador can begin its soul-searching and recover -- and investors can begin their cautious return to the market. There is precedent for this. Former President Abdala Bucaram also planned for dollarization -- before he was run out of the country.

"Ironically, the end of the Mahuad administration could be good for Ecuadorian debt prices," says Walter Molano, chief Latin America economist at BCP Securities. "Just as the departure of Yeltsin was interpreted as a positive development by investors, Mahuad's ouster could remove an important roadblock to economic recovery."