Dollarization and its Economic Impact in Ecuador and Panama

Dollarization and its Economic Impact in Ecuador and Panama: The Thousand Days’ War – a civil war that was fought before any of us were even born –  way back in 1899 –  in Columbia but had spread across Ecuador and Panama. The US took interest in the war too, for a piece of land (the Panama Isthmus).

The war may have ended in 1902, and the party that won the war in Columbia may not have been challenged for another 28 years, but it destroyed the smaller nations economically, depriving them of financial valuation as well as leading to hyperinflation and political unrest.

Ecuador and Panama were greatly affected by this war, and there were also a lot more factors into play that were crushing their economy. While Ecuador did not make hasty decisions then, it took Panama only all of two years to come to a remedial solution– in 1904, Panama was the first country in the world to become officially dollarized.

What is Dollarization?

In simple terms, dollarization refers to when a country starts using the US dollar as a major legal tender within the country. The USD can be used either as one of the two legal currencies along with the original currency of that country or as the only legal tender, by stopping the printing and circulation of the primary legal tender of that country.

There are two kinds of dollarization – official and unofficial. In the simplest of terms, when a law is officially passed stating that USD is to be henceforth used as the legal tender of the country, it’s known as official dollarization. I will not be discussing unofficial dollarization in this article because both Panama and Ecuador implemented official dollarization.

What Led to Dollarization

Panama

Panama was the first country in Latin America to dollarize in 1904, followed by El Salvador and Ecuador. The reason? As I mentioned at the beginning, the war of Thousand Days that ended in 1902 left the warring countries in a financially adverse position.

However, in the case of Panama, the reasons were based more on political and historical scenarios. The United States intervened in Colombia’s civil war because they were interested in building the Panama Canal – this canal is, to date, the most important bridge between North and South America.

Panama, since the 1850s, has been a crucial business location and transportation intermediary. International travel through the Panama Canal has always led to a huge inflow of cash in the form of US Dollars. The Colon Free Zone, established in 1948, meant that businesses were allowed to operate without paying import duties or taxes within Panama.

Thus, the natural way for ease of business and transit was to dollarize the economy. As it stood at that point in time, the population of Panama was very less, so the use of the local currency was not at all widespread, thus making the implementation of the USD easy.

Ecuador

The 1990s were very turbulent for Ecuador – careless debts owed by the government, turbulent politics, hyperinflation, soaring interest rates, and much more. In 1999, a whopping 77% of the country’s GDP was blocked in the form of eternal debts.

When 1999 began, the conversion rate for the local currency of Ecuador (sucres) to USD was at 1 USD = 4,000 sucres. By the time the year ended, the country experienced 60% inflation and a huge devaluation of their local currency.

By the end of 1999, conversion rates soared up to 1 USD = 28,000 sucres. The government had no choice but to officially dollarize the economy in the year 2000.

The Advantages of Dollarization

Panama

The biggest advantage of dollarization for Panama was the ease of business and trade. The dollarized economy also helped safeguard the assets of citizens amidst the sinking conversion rates of their local currency.

Other advantages included the betterment of macroeconomics and a fall in inflation rates. To put this into perspective, rates of inflation of Latin American countries from 1970-1998 show Panama’s rate of inflation is the lowest at 3.25%. The second and third lowest are directly 14.20 and 36.42 (Costa Rica and Chile) respectively.

Ecuador

The primary advantage for Ecuador was the valuation of their assets, financial stability, reasonable loan interests, and a lead up to a better political environment in the future.

They gained stability to such an extent that in 2014, the central bank was back with its own coins to be used for local exchanges – times were improving, volatility was decreasing and the assets are expected to shift from a dollarized valuation to local valuation within the next decade or so.

Also, the biggest advantage was that Ecuador did not have to rely on their disrupted political environment for centralized bank policies and cash flow.

Disadvantages of Dollarization

The disadvantages of dollarization depend less on the country of implementation and more on the type of implementation. Based on the scale and mode of implementation, dollarization is classified as either official or unofficial.

Panama and Ecuador both have official dollarization, but they both differ in implementation in the sense that Panama only has the USD, while Ecuador has the USD as well as domestic coins as legal tender.

Panama

The biggest disadvantage for Panama as a country is that since it no longer has its own local currency, Panama was not able to dictate or control the prices on the exports that earned them the highest revenue – oil. Also, while inflation was and continues to be at an all-time low, not having a local economy has affected its GDP growth significantly.

Ecuador

Overdependence on the US dollars has led to a situation where the market is open for all, including the wrong kinds of people. Since the central bank does not print and issue local currencies, it has no power to make monetary policies and rules that would keep fraudulent activities, unethical transactions, and corruption in check.

Wrapping Up

Dollarization is like the proverbial coin with two sides – there are experts that claim their own theories and logic are more credible than their counterparts, but the argument has been going on for a long time now, with no conclusion.

Regardless, two things are clear – dollarization is implemented in catastrophic scenarios and does serve short term benefits. However, in the long run, the country must get the valuation of the domestic currency back somehow, or the reliability on the dollar will handicap the exports, GDP, cost of living, and much more.