Abstract
In an economy that is using the US dollar as legal tender such as Ecuador, money creation is in principle impossible. But a series of legislation approved in 2009–2014, allowed an expansion of the Central Bank of Ecuador’s (BCE) balance sheet in the 2010s to finance the fiscal deficit, leaving the public sector with large liabilities towards the BCE and low reserve coverage that put the financial system at risk. This note reviews the legal and policy changes that affected the functioning of the BCE and how this institution took part of the financing of the public sector in the 2010s. A stress test analysis is performed to evaluate the liquidity impact of such policies.
Origin, Functioning and Consequences of Central Bank Balance Sheet Expansion in Ecuador1
In an economy that is using the US dollar as legal tender such as Ecuador, money creation is in principle impossible. But a series of legislation approved in 2009–2014, allowed an expansion of the Central Bank of Ecuador’s (BCE) balance sheet in the 2010s to finance the fiscal deficit, leaving the public sector with large liabilities towards the BCE and low reserve coverage that put the financial system at risk. This note reviews the legal and policy changes that affected the functioning of the BCE and how this institution took part of the financing of the public sector in the 2010s. A stress test analysis is performed to evaluate the liquidity impact of such policies.
A. Mechanism and Illustration of Central Balance Sheet Expansion in Ecuador
1. The Central Bank of Ecuador (BCE) was conceived as a reserve bank when the dollarization system was initially put in place. It is an open debate whether in a fully and officially dollarized system, a central bank is necessary, and whether an entity that enables the clearing of domestic payments and allows transactions with the rest of the world would be sufficient, e.g. this is the case in Panama. The BCE had a ban on granting credit to the public or private sector since March 2000, following the move to official dollarization. A so-called “system of four balances” was established to support the new monetary regime to ensure full coverage of the BCE obligations, since the BCE’s role of lender of last resort/money creation disappeared with dollarization. It was based on the principles of risk management to grant confidence in the financial system and the BCE operations, ensuring that BCE’s reserves were exceeding bank reserves and public sector deposits (see Box 1).
2. Between 2009 and 2014, a series of legislation were adopted that, in practice, allowed the BCE to finance the fiscal deficit. In December 2009, the BCE Board adopted a resolution that allowed the institution to acquire government bonds from public banks, and therefore increased its holding of public debt. The main objective of this process, called “Domestic Investment”, was that those resources be channeled to private companies through productive loans from public banks.2 This mechanism was reconfigured in 2012, and the transactions assigned to public banks were triangulated directly to the Ministry of Economy and Finance (MEF) to support the budget (see García, 2016). As of September 2014, the government promulgated a new Monetary and Financial Code (COMYF)3 in which this mechanism was legalized and credit operations between the BCE and the MEF were undertaken directly.
Ecuador’s Original Four Balance Rule
On March 13, 2000, the Law for the Economic Transformation of Ecuador (Ley para la Transformación Económica del Ecuador) was published in the Official Gazette. Article 33 defined the four-balance system backing rule as follows:
The first balance consisted of a fraction of the monetary base (M1), which are low denomination coins (1–5-10–25-50 cents). To balance these liabilities, an identical amount of international reserve was to be recorded on the asset side of the balance sheet of the BCE.
The second balance consisted of deposits of public and private financial institutions. To balance these liabilities, an identical amount of international reserve was to be recorded on the asset side of the balance sheet of the BCE. The law required that the first two systems always be covered by international reserves for at least 100 percent.
The third balance comprised the deposits of the non-financial public sector (NFPS). The system did not require a complete coverage with international reserves.
The fourth balance covered the remaining asset and liability accounts of the BCE, including the equity and income accounts. Once the third balance was covered, its remnant was to be added to the assets covering the fourth balance.
3. The following illustrations expose how the BCE balance sheet was expanded:
Figure 1 represents the initial state in which the central bank is a reserve bank, with a high ratio of liquidity to liabilities, just as the BCE in the early 2000s. Assets include international reserves and non-financial domestic assets. The liabilities side is composed of resources of private and public financial institutions, as well as the deposits of all the entities of the non-financial public sector (NFPS). To complete the balance sheet, there are other liabilities and equity. In this example, the reserve coverage ratio is 75/ (20+10+40) = 107 percent.
The so-called “Domestic Investment” mechanism was an accounting process where the BCE acquired unmarketable and unfunded securities from the public banks. Therefore, in practice the BCE invested in public banks without its own resources, i.e. with an electronic accounting record. The BCE balance sheet was expanded with the purchase of public bank securities that translated in an increase in central bank liabilities. This process is illustrated in Figure 2. Suppose that the BCE invests 20 in public banks. On the asset side, illiquid domestic financial assets (which are IOU issued by public banks) increase, while on the liability side, public bank resources at the BCE increase by the same amount. The BCE’s balance sheet is artificially expanded because if those obligations were to be called, the BCE would have to use cash, i.e. international reserves. The international reserves are still 75, but liabilities are now 90 (20+30+40), therefore the reserve coverage goes down to 83 percent.
Ecuador: BCE as a Reserve Bank
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Ecuador: BCE as a Reserve Bank
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Ecuador: BCE as a Reserve Bank
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Ecuador: BCE’s Balance Sheet Artificially Expanded
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Ecuador: BCE’s Balance Sheet Artificially Expanded
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Ecuador: BCE’s Balance Sheet Artificially Expanded
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
4. As illustrated, the mechanism of central bank balance sheet expansion in a dollarized system raises the probability of foreign default as it decreases the reserve coverage ratio. In Ecuador, by 2014, BCE credits to public banks peaked at about 3 percent of GDP (text chart). As of March 2021, the outstanding public banks’ debt to the BCE is US$1.3 billion. Given fiscal difficulties following the fall in commodities prices in late 2014, this mechanism grew significantly from October 2015 to May 2017 to reach close to US$7 billion, over 7 percent of GDP. Currently, the Ministry of Economy and Finance owes the BCE approximately US$6 billion.4
Stock of Credit Granted to Public Banks and Central Government, Jan-2009to Mar-2021 1/
(In US$ millions)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Source: BCE.1/ Includes public bank share in “dacioneri pago.”Stock of Credit Granted to Public Banks and Central Government, Jan-2009to Mar-2021 1/
(In US$ millions)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Source: BCE.1/ Includes public bank share in “dacioneri pago.”Stock of Credit Granted to Public Banks and Central Government, Jan-2009to Mar-2021 1/
(In US$ millions)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Source: BCE.1/ Includes public bank share in “dacioneri pago.”
Private Banks Deposits at BCE and Growth Rate of Credit to the Private Sector, Jan-2014to Mar-2021
(In US$ millions)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Source: BCEPrivate Banks Deposits at BCE and Growth Rate of Credit to the Private Sector, Jan-2014to Mar-2021
(In US$ millions)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Source: BCEPrivate Banks Deposits at BCE and Growth Rate of Credit to the Private Sector, Jan-2014to Mar-2021
(In US$ millions)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Source: BCE5. Since the expansion of central bank balance sheet works as a multiplicator, it raised deposits and ultimately affected the balance of payments, through capital outflows. From the perspective of the balance sheet of the public institutions that were credited by the BCE, there is also an expansion of their balance sheets. Assets increase, since they have more resources at the central bank and translate in public spending that utimately transit to private financial institutions, increasing thereafter there liquid resources at the BCE. These reserves at the BCE have no remuneration and are an opportunity cost for financial institutions. The natural response of banks and cooperatives was to increase the offer of credits (text chart). Following the stiff contraction in 2015 due to the fall in oil prices and the resulting economic contraction, the growth rate of credit to the private sector rebounded from mid-2016 to reach a growth rate of 12%-18% between mid-2017 and mid-2019. Problems can emerge when BCE clients, now with more resources, decide to make payments abroad or demand cash. Since there is no more full coverage of liabilities by international reserves, it creates a liquidity imbalance for the central bank and ultimately put the financial system at risk.
B. Stress Test Analysis
6. A stress test method consists of gauging each month what the reserve coverage would have been without future external public debt disbursements. It is assumed that no new public financing is obtained, but external payments, both public and private, will continue. The objective is to determine the number of months that international reserve can cover without the inflow of new resources from public external debt. It is both a liquidity and a financing stress test since the more the international reserve can cover liabilities without the need for external debt, the more liquid is the central bank to cover its obligations and the less dependent the government becomes on this external source of financing. This can be viewed as a benchmark, such as for example international reserves to months of imports commonly used. This methodology can be illustrated as follows (text chart): In January 2014, it is assumed that no new public external disbursements are received onward. In this circumstance, it would have taken seven months for the international reserves to reach US$2 billion, eight months to reach US$500 million, and reserves would have been exhausted after nine months. This exercise is replicated for each of the 84 months between January 2014 and December 2020.
International Reserves: January 2014 Stress Test Results
(In US$ millions)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Source: BCE and IMF staff calculations^International Reserves: January 2014 Stress Test Results
(In US$ millions)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Source: BCE and IMF staff calculations^International Reserves: January 2014 Stress Test Results
(In US$ millions)
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Source: BCE and IMF staff calculations^7. Our results indicate important liquidity shortages starting end-2015 and exacerbating in 2018, when the Ecuadorian authorities started negotiation on a program with the IMF. Using a heat map, we present results for each of the months from January 2014 through December 2020, arranged in columns. In rows, we present a continuous threshold where we applied the methodology to determine the liquidity pressures at each point in time ranging from zero to US$2 billion. The result is expressed in the number of months that international reserve will take to reach the defined threshold. The values found vary between 2 and 8 months. In other words, there are specific months in which international reserve would have last two months or less without the need of new external debt inflow. The range of colors reflects these results; the greenest color corresponds to values above 8 months, and the reddest values below 2 months. Focusing on the average line at the bottom, very high-risk levels, i.e. below 2 months on coverage, are recorded in 4 of the 84 months of analysis. In 14 months, international reserves can only withstand three months without new financing. In other words, in 21 percent ((14+4)/84) of instances between 2014 and 2020, the BCE was in a situation where its liquidity horizon was less than three months. Overall, there were very few months in which the BCE had sufficient amount of international reserves, but liquidity pressures were exacerbated in the year 2018, that recorded 7 of the 18 high-liquidity stress episodes.
Ecuador: Results of the Stress Test—Heat Map
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Ecuador: Results of the Stress Test—Heat Map
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
Ecuador: Results of the Stress Test—Heat Map
Citation: IMF Staff Country Reports 2021, 229; 10.5089/9781513599274.002.A004
C. Conclusion
8. We illustrated how an expansion of the Central Bank of Ecuador’s balance sheet put the financial sector, and ultimately the dollarization system, at risk but also put significant stress on the cash position of the public sector. Using a stress test-like methodology, we documented how an expansion of the balance sheet of a central bank in a dollarized economy generated a need for external resources, given the increase in liabilities that could be demanded for foreign payments or cash needs. To solve the liquidity shortages, the Ecuadorian government relied on obtaining external debt through the issuance of sovereign bonds and bilateral loans, and with multilateral organizations more recently. Ultimately, this left the Ministry of Economy and Finance (MEF) with large outstanding obligation towards the BCE that remain a significant legacy, in particular during difficult times.
9. To fortify the institutional foundations of the dollarization system, Ecuador reversed the 2014 amendments to the COMYF in 2021. Amendments to the COMYF were approved by the National Assembly and published in the Official Gazette on May 3, 2021. One of the main objectives of those amendments was to prohibit all future quasi-fiscal activities of the BCE as well as direct and indirect lending to the government or public sector (including loans, advances, guarantees or transactions that indirectly support lending operations of the public sector). Additionally, the law seeks to strengthen the central bank’s autonomy and governance arrangements and to strengthen the central bank’s financial stability oversight function. Ultimately, the law seeks to achieve full coverage of liabilities with international reserves by 2035, a return to the so-called “four balances”.
10. IMF technical staff team is working together with the authorities of the BCE to ensure the financial balances are in line with international financial standards (IFRS). The unmarketable and unfunded securities (IOU’s) received from the public banks and Central Government would likely have been significantly lower in value upon origination in fair-value terms. This reduction in value on origination would have either: (i) reduced the BCE’s ability to invest as much in the public banks or Central Government; or (ii) the BCE would have had to record a loss on origination, which would have eroded the BCE’s equity. The application of international recognized accounting standards would have made the risks more apparent, potentially reducing the motivation to have undertaken them in the first place.
References
Garcia, C., 2016. “Análisis de la inversión doméstica y su incidencia en la colocación de créditos de la banca pública. Caso BNF, BEV, CFN y BdE. Período 2009–2013”. Pontificia Universidad Católica del Ecuador
Prepared by Juan Pablo Erraez and Julien Reynaud (WHD).
The Board of Directors of the Central Bank of Ecuador issued Regulation No. 200–2009 on September 24, 2009, creating the Domestic Investment Program with the objective of "... channeling surplus liquidity from the different sources of public savings to the national economy, through public financial institutions and reimbursable financial instruments...".
On June 30, 2021, the MEF and the BCE signed an agreement whereby the MEF bought-back the outstanding debt of public banks at the BCE, clearing legacy assets from the balance sheet of the BCE and increasing its liquidity (https://www.bce.fin.ec/index.php/boletines-de-prensa-archivo/item/1436-el-gobierno-fortalece-la-liquidez-del-banco-central-y-protege-la-dolarizacion).
