Ecuador’s economic history has not been a happy one. A lack of national cohesion has dogged the country ever since it opted for independence from Simon Bolivar’s Grancolombian Federation in 1830. From the start there was fierce rivalry between the residents of the highlands, centered on the capital Quito, and those on the coast, centered in Guayaquil. Fortunately, though, these rivalries did not lead to violent confrontation, and Ecuador’s history, although turbulent, has been peaceful. However, the deep split between the interests of the coastal and highlands regions has at times—and certainly during the last five years—made it almost impossible for the government to pursue a coherent economic policy.Stanley Fischer (2001)
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I thank, without implicating, María Caridad Araujo, Jorge Cayazzo, Carlos Cobo, Augusto de la Torre, Stefan Ingves, Jens Nystedt, Marc Quintyn, Bob Traa, Marco Varea, Mauricio Villafuerte, Delisle Worrell, Mayra Zermeño, and participants in the seminar in the IMF’s Monetary and Financial Systems Department.
In this paper, the term “institutions” refers to organizational and regulatory aspects underpinning government decisions—in the present case, those relevant to the functioning of the financial system. Public finance rigidities refer to the government’s limited ability to increase revenues and cut expenditures and to their difficulties in accessing capital markets in order to finance fiscal gaps. Financial dollarization refers to the extensive use of a foreign currency—in this case, the U.S. dollar—to value assets and liabilities in the financial system, while real sector transactions are mostly denominated in domestic currency.
The study is not meant to convey the message that financial dollarization per se is necessarily negative. Recognizing that financial dollarization creates benefits, in particular in inflationary economies, since it allows countries to maintain financial depth (see De Nicoló, Honohan, and Ize, 2003), the paper claims that during periods of financial turbulence, financial dollarization adds a negative dynamic to banking crises, complicating their management and making the country more prone to a simultaneous currency crash (see Ingves and Moretti, 2003).
According to the results of the National Survey performed by National Institute of Statistics and Surveys (INEC), during 1999–2001, about 300,000 Ecuadorans (mostly workers) left the country. Other studies estimate that migration totaled 500,000 persons between 1998 and 2002. In any case, these are significant numbers in a country of less than 13 million inhabitants.
For an analysis of the institutional setting relevant to the financial system in Ecuador see de la Torre (1997) in relation to the mid-1990s banking problems and Patiño (2001) with respect to the late 1990s banking crisis.
As examined by Hurtado (1997), the conduct of government policies in Ecuador has been historically driven by political and economic interest, which many times sought to defend or add privileges at the expense of the well being of the majority of the population.
See the previous work by Sundararajan and Baliño (1991) on the 1970s and 1980s banking crises, Dress and Pazarbaşioğlu (1998) on the early 1990s Nordic banking crises, Hausmann and Rojas-Suárez (1996) on the mid-1990s Latin American banking crises, and Lindgren and others (1999) on the Asian banking crises.
Ecuador had suspended payments on its external commercial debt back in 1987.
Political confrontations prompted the resignation of the Vice President of the Republic, the leader of the government’s stabilization policies and structural reforms, in a nation that was emerging from a lengthy inflationary period and has been traditionally opposed to structural reforms.
Fiscal adjustment was adopted in the context of macroeconomic programs negotiated with the IMF—seven agreements between 1980 and 1997—aimed at improving the overall macroeconomic performance, and in particular to reduce inflation. However, only one of these agreements was successfully completed—in 1983.
The price of Ecuadoran oil exports had trended down such that by end-1990s it was less than the price prevailing during the mid-1970s in nominal terms.
Earmarking from tax revenues has been more transparent than that from oil revenues, which were built on a complex system where the distribution of resources among earmarking participants was influenced by the performance of oil export prices and the exchange rate, and by changes in domestic oil prices.
The main provision of earmarking stems from the 1978 Constitution, which established the allocation of 30 percent of government revenues for educational purposes. The 1998 Constitution also allocated 15 percent of government revenues to local governments without establishing the associated spending responsibilities.
Up to that year, the CBE had capped financial intermediation interest rate spreads and banks had to surrender foreign exchange to the CBE under a preannounced crawling peg system.
As an example, the CBE absorbed commercial banks’ foreign currency obligations and simultaneously converted into sucres its claims on commercial banks, thereby preventing an incipient banking crisis in 1983. Since the new domestic currency debt was restructured at below market conditions, the CBE amassed huge losses, which were not compensated by the government (see Samaniego and Villafuerte, 1997)
The number of finance companies—not authorized to take deposits but allowed to issue financial certificates—also increased from 9 in 1992 to 45 in 1995.
The latest of these events had taken place in 1988, when the Monetary Board required the CBE to buy external public debt at face value to commercial banks, although in the secondary market it was priced at a steep discount since Ecuador had defaulted on its external debt in 1987. Profits from these transactions would cancel commercial bank liabilities with the CBE, including reserve requirement shortages. Samaniego and Villafuerte (1997) calculate that the difference between the nominal and the face value of theses securities mounted to 2.4 percent of GDP and to more than total equity of the beneficiary institutions.
Banco Central del Ecuador (1996) records a sequence of fraudulent operations committed by Banco Continental.
While the central bank granted emergency support to this bank, providing additional assistance was not possible because it had to be legally approved by the CBE Board, which had not yet been nominated by the recently elected government at that time.
Measured in foreign currency, dollar deposits rose 12 percent.
Such a last resort decision has also been adopted from 1990 onward by Finland, Honduras, Indonesia, Jamaica, Japan, Korea, Kuwait, Malaysia, Mexico, Sweden, Thailand, and Turkey, in the wake of systemic financial crises (see Garcia, 2000).
P&A refers to financial transactions where a solvent bank purchases a proportion of the assets of a problem bank and assumes a proportion or all of its liabilities. In the event that purchased assets are worth less than the assumed liabilities, either the government or a bank restructuring institution—if it exists—would provide the resulting difference in the form of liquid assets to match the value of assets and liabilities to be acquired by the purchasing bank.
Ecuador’s deposit freeze was more aggressive than others adopted in the region, such as Argentina’s Bonex Plan and the Collor Plan in Brazil (see Cardoso and Rigobon, 1999), the recent Uruguayan reprogramming of deposits in 2002, and the composite “corralito” and “corralon” in Argentina 2002.
CDRs were issued at depositors’ request and were usable to buy durable consumer goods and real estate.
Strictly speaking, Banco del Progreso’s main shareholder decided unilaterally to close the bank claiming that his bank had received insufficient financial assistance from the CBE. Unexpectedly, rather than liquidating the bank, as it was required by the LFSI, the government authorized the banker to continue working within the bank while it was closed and provided him 90 days to capitalize. Eventually, the bank’s main shareholder never injected capital and hence the AGD took control of the closed bank.
The negative 234 percent risk-weighted-capital-asset ratio as of March 1999 calculated by the international audits for Banco del Progreso illustrates such divergences since the SBS had not found insolvent this bank beforehand.
This amount is comparable to the liquidity support provided in Malaysia, 13 percent of GDP, and is smaller than the assistance provided in Indonesia and Thailand, 16 and 22 percent of GDP, respectively during the Asian crisis (see Hoelscher and Quintyn, 2003).
Banco Previsora was taken-over by the AGD-owned Filabanco while Banco del Pacifico was merged with the CBE-owned Banco Continental.
A final judgment about the lasting benefits of Ecuador’s dollarization is beyond the scope of this paper.
Modern economic literature is increasingly highlighting the role of institutions in explaining differences in the quality of governments and their policies, and in the level of income and development between countries (see for example the recent papers by Acemoglu et al., 2002 and Rodrik et al., 2002), but the link between quality of institutions and financial crises events has received no attention in the literature. From a policy perspective, however, there is recognition of the relevance of institutional aspects by the official international community. The Financial System Assessment Program developed by the IMF and the World Bank, which is being executed since 2000, includes an assessment of the countries’ observance of Basel Core Principles for effective banking supervision, of transparency practices, and of the legal and institutional framework to prevent the stability of financial systems and to manage banking crises.
The management of Sweden’s banking crisis in the early 1990s is a case in point since the rule of law and institutions’ strength, underpinned by a broad political consensus to handle the crisis, allowed the Swedish government to contain increasing bank distress that had challenged stability at a systemic level. Like Ecuador, the Swedish government brought in a blanket deposit guarantee and created a bank-restructuring bureau; unlike Ecuador, the Swedish government was able to adopt effective bank resolution decisions to quickly restore markets’ confidence in the banking system without imposing a high fiscal cost on the economy (see Ingves and Lind, 1996).
The role of fiscal policy during financial crises has been intensively debated over the last few years, in particular following the Asian crisis. In a Keynesian setting, the discussion has basically focused on whether the government should play a pro-cyclical or a counter-cyclical role during financial crises given that the fiscal stance contributes to deepen or mitigate the crisis’ contractionary effects via its impact on aggregate demand. However, this debate is relevant under circumstances where fiscal imbalances and a high debt burden are not a source of macroeconomic vulnerability or when fiscal weakness is not the root of the crisis. In such scenario, not tightening fiscal policy makes economic contraction stemming from financial crises less severe, which in the end reduces the associated negative effects on bank assets.
In this regard, Ecuador shows some similarities with the Indonesian crisis, where governance problems intensified the 1997 financial crisis and delayed its resolution (see Enoch and others, 2001).
The modality of honoring the blanket guarantee followed the mandate of the State Lawyer who required cash payments—printing money given fiscal constraints—rather than delivering the deposit guarantee with government bonds.
Implementing P&A typically require conducting technical procedures to assure that the orderly transfer and payoff of deposits is executed smoothly, on time, and transparently (see He and Seelig, 2000).
Typically, under these transactions, AGD bonds were sold to state-owned institutions at face value after having been acquired by particulars with a big discount in the secondary market.
In Uruguay, only the viable banks were opened at the end of the bank holiday in mid-2002, and hence, only a reduced reprogramming of bank deposits was necessary. As a result, the damaging effect to the payments system was mitigated, adverse selection was avoided, and further contagion was contained. Moreover, the Uruguayan government’s discrimination between viable and unviable banks contributed to gradually restoring confidence in the banking system, and hence, marked the beginning of the turn around of the banking crisis as opposed to what happened in Ecuador, where the bank meltdown continued after the bank holiday. In the other two countries, no reprogramming of deposits was necessary.
As a way of comparison, with a strong fiscal position and a low debt to GDP ratio the Dominican Republic was able to raise US$600 million (about 3 percent of GDP) in the international capital markets during the early phase of the 2003 banking crisis. Access to capital markets allowed the government to underpin central bank’s international reserves, and hence, to mitigate the initial pressures on the domestic currency.
Other countries in Latin America (Argentina, Brazil, Colombia, Peru, and Venezuela) had brought in similar taxation over the 1990s, but the tax base was typically narrower and the rate smaller (see Kirilenko and Perry, 2003).
Mexico during the mid-1990s, the Asian countries in 1997 and 1998, Colombia in 1999, and more recently Uruguay (2002), and the Dominican Republic (2003), illustrate the benefits of an early IMF support, while Venezuela during the mid-1990s and Argentina in 2002 provide examples in the opposite sense.
The replacement of the income tax with the financial tax was instrumental in slowing down the pace of Ecuador’s negotiations with the IMF.
In this regard, the Ecuadoran crisis episode does not oppose necessarily the conclusions from Arteta (2003), who finds no empirical evidence that financial crises are more costly in highly dollarized economies and that macroeconomic and exchange rate policies are more important.
The Argentinean and Uruguayan financial crises record a similar experience.
See Arteta and Hurtado (2002), who addresses recent political and economic legal instability in Ecuador.
See Alesina and others (2003) on the importance of ethnic, linguistic, and religious differences in explaining economic growth, the quality of institutions, and government policies.
Ecuador’s bipolar development seems to better fit the concept of “polarization” proposed by Garcia-Montalvo and Reynal-Querol (2002), which they also find empirically, has an indirect negative effect on economic growth. Typically, polarization is maximized when there are two groups of equal size—like the Coast and the Sierra in Ecuador.
The influence of ruling elites to funnel society’s savings toward their own benefit is not an Ecuadoran exclusive feature as it has also been observed in other countries in the region (see Haber, 2002). Moreover, this is a subject of interest in relation to theories of financial development of countries (see for example Rajan and Zingales, 2003).
De la Torre (1997) notes that the legislation brought in with the 1994 reform gave Ecuador a “Chilean style” legal framework for a non-Chilean environment, meaning that the reforms presupposed the existence of stable macroeconomic conditions and high quality prudential supervision of financial intermediaries—conditions that were not observed in Ecuador.
In a systemic crisis sound banks will rather prefer to preserve their own liquidity than to lend to an impaired bank in anticipation of potential deeper liquidity problems.
The handling of the 1995 Banco Continental debacle is a case in point.
See Jácome (2003). By way of comparison, Ecuador’s neighbors Colombia and Peru had only two central bank governors each between 1990 and 2000.
Liquidity assistance was lent at market rates up to 180 days, in exchange for real or financial assets of the impaired bank.
Furthermore, the 1998 Constitution was explicit in authorizing the CBE to assist to banks that were experiencing solvency problems “until the State has suitable legal instruments for managing financial crises.”
While a deposit insurance mechanism had been recently approved by Congress, it was still waiting to be enacted by the executive branch when the banking crisis erupted.
The deposit guarantee coverage varied as it was tied to an inflation-indexed unit. Expressed in dollars, that value depended on the performance of the real exchange rate.