IPO and Dollarization

Economic Stability and Uncertainty Combined: The Impact of Dollarization on the Ecuadorian Economy and United States

Trade, 2004-2010 Ramon Vasconcellos MA, MBA Grace Nicklaus Professor, Barstow Community College International Business Major, Finance Minor 2700 Barstow Road California State University, San Bernardino Barstow, CA, 92311 5500 University Parkway (760)252-2411, ext. 7329 San Bernardino, CA, 92407 United States of America (760)701-0060 [email protected]; [email protected] [email protected] ABSTRACT This paper examines the socio-economic impact of Ecuador’s adoption of the United States Dollar as their official medium of exchange, and its impact on U.S/Ecuadorian trade agreements. The areas of financial services, import-export, and exchange rate fluctuations are studied as a means of assessing their influence on Ecuador’s public and private sectors subsequent to the agreement. Particularly, the research explores how globalization, regarding intercontinental currency adoption, has both stymied and expanded regional economies. Supporting data include –but are not limited to- testimonials from trade representatives and World Bank statistics, along with Ecuadorian trade and industrial figures.

Keywords Dollarization; Value at Risk (VAR); Pegged Currency Systems; Balance of Payments; Tariff Rate Quotas (TRQs); Great Recession; International Monetary Fund (IMF); Gross Domestic Product (GDP); Transfer Pricing

INTRODUCTION

According to the Office of the United States Trade Representative, Ecuador serves as the 40th largest goods provider to the United States with $12.9 billion exported to the U.S. in 2010; the trade deficit with Ecuador was $2 billion that year. Further, U.S. trade in 2010 increased by 41.3% over 2009, with a resounding 331% escalation from 1993.1 In 2010, U.S. imports amounted to $869 million in agricultural goods such as bananas and plantains, cut flowers, and cocoa beans. Ecuadorian imports from the U.S. –accounting for 26% of her imports- consisted of paper, chemical products, electrical and transportation equipment, 1 Office of the United States Trade Representative, pg. 2;

http://www/ustr.gov/countries-regions/america/ecuador

and fertilizers. At the same time, mining and manufacturing received the most foreign direct investment (FDI) from the U.S. accounting for $1.3 billion in 2009.2

DOLLARIZATION

Adoption of the U.S. dollar in 2000 contributed to the expansion of trade between the two countries for dollarization (the process whereby a foreign country adopts the U.S. dollar as its official medium of exchange) resulted in abandonment of the Sucre, which had contributed to spiraling inflation and a banking crisis during the late 1990. In turn, greater price stability and increased purchasing power improved most Ecuadorians’ standard of living, in addition to attracting foreign capital.

For example, the economy had contracted at a rate of -7.3% in 1999, but grew by 2.3% and 5.6% in 2000 and 200l, respectively.3 After posting moderate gains throughout the last decade, growth slowed to a 3.6% rate for GDP in 2010, with the forecast for 2011 estimated to be 5.1%. Given dollarization, per capita income increased from $1,324 in 2000 to $4,013 in 2010,4 with the poverty level declining from 51% to 33% for the same period. 5

2 Ibid 3 The Effect of Dollarization in Ecuador;

http://www.mindspring.com/tbgray/dollar.htm 4 U.S. Department of State-Bureau of Western Hemisphere Affairs

http://www.state.gov/r/pa/ei/bgn/35761.htm 5 Office of the United States Trade Representative, pg. 8

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Throughout the first five years of the new millennium, Ecuador’s economic growth averaged 4.9% per annum as oil production expanded, along with increased consumer demand and exports. The same period witnessed Real Gross Domestic Product expanding at a 2.1% rate for the oil sector with the opening of a new oil pipeline in 2004, Oleoducto de Crudos Pesados (OCP). Other major pipelines have augmented growth as well: Sistema Oleoducto Trans- Ecuatoriano (SOTE), located in the Amazon region of the country extending to the Pacific, and Oleoducto Trans- Andino (OTA), running from the Amazon to Columbia’s Pacific port of Tumaco. 6

ECONOMIC GROWTH AND INFLATION

Prior to the adoption of Dollarization, Ecuador and the United States had agreed to a Bilateral Investment Treaty (BIT) signed in August of 1993. The BIT gave the U.S. Most-Favored-Nation (MFN) status requiring that any expropriation be carried out specifically for “public purpose, in a non-discriminatory manner, and upon payment of prompt, adequate and effective compensation.” For the most part, U.S. companies have been protected under the BIT agreement. However, the judicial system has sometimes acted contrary to the treaty. In the case of Occidental Petroleum, the government accused the oil company of selling part of its operating contract to EnCana, a Canadian subsidiary, without approval. As a result, the U.S. froze talks of a free trade agreement which was under review in 2006 between Ecuador and the United States.7

Yet, the cost of a developing economy has been accelerating inflation. Although inflation had dropped precipitously after dollarization, consumer prices did rise from 2007-2009. Ivan Gachet, Diego Maldonado, and Wilson Perez have defined the causes of a recent spike in the Consumer Price Index through the application of Value at Risk (VAR) modeling.8 A Value at Risk (VAR) model identifies relationships between economic variables by assessing risks associated with portfolios. Gachet et al modified the formula to include variables causing changes to inflation in assessing empirical relationships among data. As a result, the SVAR (Structural Value at Risk model) was applied in measuring aggregate sources of inflation.

6 Steven T. Anderson, “The Mineral Industry of Ecuador,” U.S. Geological Survey Minerals Yearbook, 2004. pg. 10.3 7 U.S. Department of State-Bureau of Western Hemisphere Affairs

http://www.state.gov/e/eeb/rls/other/ics/2009/117668.htm 8 Ivan Gachet, Diego Maldonado, and Wilson Perez, “Determinants of Inflation in a Dollarized Economy: The Case of Ecuador.” Cuestiones Economicas Vol. 24, No. 1:1-2, 2008. pg. 7-10

Drawing from SVAR modeling techniques, which identified CPI changes related to the money supply and wages in the U.S., lending practices in Switzerland, and oil shocks to industrialized countries, Gachet et al concluded only 7.75% of inflation resulted from government policy emanating from Quito. International commodity prices and exchange rate fluctuations, however, accounted for 62.04% and 18.49%, respectively, of Ecuador’s 2008 first quarter inflation.9

Consequently, research in the area of U.S. macroeconomic shocks on international commodity prices and changes in the valuation of the United States Dollar (USD) evidence reverberations felt by our trading partners. Messrs. Kyong wook Choi, Shawkat Hammoudeh, and Won Joong Kim have cited oil prices, changes in U.S. output, the real exchange rate, and the U.S. consumer price index as having contributed to global supply side shocks.10 For example, a weaker dollar often leads to more expensive oil imports and higher domestic prices for global commodities. As mentioned, Ecuador maintains sufficient oil and gas resources for domestic consumption. Nevertheless, that country’s non-fuel commodity prices have increased, partly because of the overall weakness in the USD. Dollarization, while allowing for cheaper Ecuadorian exports, has, in part, ignited recent inflation.

PEGGING: BENEFITS & COSTS

Pegging is tying one nation’s currency to another or a portfolio of currencies. The practice has distinct advantages and disadvantages. One benefit is the economic stability often created in the absence of a depreciated currency. Political constancy is another factor given that the government could, perhaps, gain some measure of acceptability with its constituents. Speculation and/or “front running,” as is common under floating currency systems, are reduced. Liquidity requirements for currency and capital markets are sometimes unnecessary since the pegged currency will often suffice as collateral reserve.11

Still, disadvantages often arise. A country might have to adopt austerity measures similar to that of the peg country, which could serve to undermine its public sector. Currency

9 Ibid, pg. 7 10 Kyongwook Choi, Shawkat Hammoudeh, and Won Joong Kim, “The Effects of U.S. Macroeconomic Shocks on the International Commodity Prices.” Unpublished Paper 11 J.Ashok Robin, International Corporate Finance (McGraw Hill Press. 2011), pg. 96

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boards may have to intervene to preserve the initial target exchange rate; in doing so, reserves may be required.12

Conditions requiring the adoption of a peg as the official medium of exchange are set by the International Monetary Fund (IMF). If a country has little or no involvement in international capital markets, pegging is advised. Significant levels of trade with the pegged country and a desire to adopt its monetary policies is another condition.13Flexible labor markets and fiscal policies are also prerequisites. Excessive monetary growth and significant holdings of international reserves of the peg country are viewed by the IMF as sufficient reason for pegging, too.

IMPROVEMENTS IN THE STANDARD OF LIVING

On balance, the Ecuadorian economy has experienced significant improvements in its standard of living, while witnessing declining innovations in certain industries. As discussed, inflation, with the exception of 2008, has been tamed. Since 2004, Chinese, Taiwanese, U.S. and Latin American imports are “flooding” the shopping centers giving consumers broader choices. The Central Bank of Ecuador reported that leisure and tourism industries increased from 27.6% to 31.2%14 between 2000-2003 and, barring the Great Recession, continue to grow throughout 2011. However farmers, small scale merchants, and manufacturers had difficulty accessing credit from 2000- 2004 with agriculture and forestry production declining to 8.8% from 10.6%. 15

In 2004 Luis Rosero, director of the Research Center of the University of Guayaquil, commented that the beneficiaries had been those entrepreneurs in the service sector. According to Rosero, “[Dollarization] does not generate wealth from exports…it is reducing industry and increasing imported goods.”16 Furthermore, Rosero opined that exports would improve if productivity rises and aggregate industrial overhead costs decline. At the time, unemployment hovered around 11.9% with few dollars circulating in the hinterland. However, in light of the Great Recession, unemployment declined to 8.3% in second quarter 2009 and 6.4% for the same period in 2011.

12 Ibid, pg. 97 13 Ibid 14 The Effect of Dollarization in Ecuador, pg. 3 15 Ibid 16 Ibid

Politically, dollarization moderated the influence of the Central Bank given what had been loose monetary policy promoting the circulation of the Sucre. Also, the economy had undergone a banking crisis prior to 2000 making calls for economic reforms essential. Some policy makers have concluded that adoption of the U.S. dollar has resulted in increased consumer purchasing power quelling, albeit, perhaps, temporarily, calls for labor reforms.

In Ecuador, the Balance of Payments, an accounting system measuring trade and financial transactions between a country and its competitors, registered an $817 million Current Account deficit in first quarter 2009,17 although improving in 2010. Remittances, those payments made by subsidiaries of Multi-National Corporations (MNC’s), have shown marked decreases to Ecuadorian companies due to the financial crisis; $555 million remittances were received in first quarter 2009 - an annual decrease of 27%. In the second and subsequent quarters, remittances were $610 million, indicative of a recovery underway. 18

Aside from the economic gains which have accrued from dollarization and trade agreements with the U.S., the government has increased social spending from 5.4% of GDP in 2006 to 8.3% in 2008. Also, cash transfer payments to the poorest households and spending on homeowner assistance measured a $474 million increase for the same period.19 As a result, the Correa government has seen percentage rates of those living below the poverty line decreasing from 2009-11. Citing the dollar as a complete failure20 in 2007, President Correa agreed to maintain dollarization, but stated his government would renege on pledges to repay debt to the IMF.21 Consequently, spending for public service programs in education and healthcare has increased, with payments on debt service dropping to 15% of GDP. One academic remarked how “dollarization was a failure in the sense that it widened the gap between the rich and the poor,” yet maintained that “the cost of leaving behind the dollar as the local currency would be very high.”22

17 Republic of Ecuador, “Ecuador, Macroeconomic Overview, Oct. 2009.

www.bce.fin/ec/documentos 18 Ibid 19 Mark Weisbrot and Luis Sandoval, “Updated on the Ecuadorian Economy,” Center for Economic policy Research- 2009 20 Ibid 21 Matthew Walter, “Ecuador Plans Spending to Reverse Dollar’s ‘Failure’” www.bloomberg.com/apps/news?pid 22 Ibid

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TRADE BARRIERS

Tariff Rate Quotas, taxes imposed on agricultural imports in order to protect domestic producers, have been affixed to certain agricultural products as a means of protecting Ecuadorian farming communities. Under the Andean Price Band System (APBS), an agreement on tariff schedules adopted by those members of the Andean Group -Bolivia, Columbia, Ecuador, Peru and Venezuela- Ecuador maintains tariffs on 153 agricultural goods.23 The country did commit to eliminating TRQ’s as part of the Uruguayan Round in 1996; however, enforcement has been lax in order to protect local producers. Goods subject to TRQ’s include wheat, corn, sorghum, barley, soybean meal, powdered milk, and frozen turkeys and chickens.

Non-agricultural goods are also subject to special taxes and import restrictions. For example, consumption taxes are assessed on imported and domestic spirits. In 2006, a Food and Nutrition Security Law prohibited the importation and trade in food products containing organisms derived from biotechnology: soybean meal and cooking oil.24 Still, imports of such products did continue as the country sought guidance as how to enforce the regulations.

Investment barriers have eroded significantly between 2004 and 2009. Foreign investors are allowed 100 percent ownership in many investment sectors, with few controls or limits on the transfer of capital goods. However, investment in petroleum has significant controls requiring foreigner’s contract with state oil companies. Ivanhoe Energy, a Canadian based petroleum exploration firm, has drilled wells in the Pungarayacu region of Amazon.25 These wells were first put into operation by Petroecuador in the 1980s followed by Ivanhoe’s continued exploration of the region. The firm applies Heavy-to-Light (HTL) oil upgrading technology in its extraction of crude; in July 2010, the company reported that its Pungaraycu well had been successfully dug. However, “cementing and completion problems”26 had rendered another well inoperable with no oil recovered.

23 Unite States Trade Representative; www.ustr.gov/sites/defaults/files/ updates 24 Ibid 25 “Ivanhoe Energy Successfully Upgrades Heavy Oil from Ecuador Field to Pipeline Quality,” www.new.techmagazine.com/news/ivanhoe-energy 26 Ibid

Impediments to capital formation, however, continuously hinder investment. Some oil companies have had disputes with the government over value-added-tax refunds. An amendment to a hydrocarbons law which increased the amount of revenue accruing to the government has resulted in the bankruptcy of at least one U.S. oil firm. Underpayment to U.S. investors in the electricity sector emanates from government subsidization of local providers, and a reluctance to cut off those customers who refuse to pay their utility bills. Also, the expropriation of properties by government often involves a lengthy period of time before investors are adequately compensated.27

U.S. industries with the most exposure to Ecuadorian markets, having an aggregate value in excess of $30 billion USD in exports in 2008, were a conglomerate of heavy machinery, industrial supplies, and iron and steel. Civilian aircraft accounted for $38.6 million in 200828, a substantial increase over 2007 of 753%; excavating machinery generated $142.6 million in 2008. Other industries showed significant gains prior to the financial crisis, with iron and steel mill products up 298.6% in 2008 and special purpose vehicle exports registering $60.5 million.29

CONCLUSION

Adoption of the USD has definitely augmented trade growth between the United States and Ecuador; in the case of the former, the U.S. imports significant amounts of agricultural goods. Ecuador, in turn, has enhanced her standard of living through economic stabilization and the promotion of local industry. Although uncertainties still exist concerning capital formation and the growth of undeveloped markets, Ecuador offers niche opportunities in franchises and infrastructure development. Further, in spite of challenges presented due to the global financial crisis, dollarization has developed an attraction for U.S. products and services and continues drawing foreign capital to Ecuador.

REFERENCES

Anderson, Steven T. “The Mineral Industry of Ecuador,”

U.S. Geological Survey Minerals Yearbook, 2004

27 Unite States Trade Representative; www.ustr.gov/sites/defaults/files/ updates 28 “Top US Imports & Exports with Ecuador in 2008”; http://daniel- workman.suite 101.com/top-us-imports-exports-with-ecuador-in-2008 29 Ibid

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Beckerman, Paul. “Dollarization and Semi-Dollarization in

Ecuador,” The World Bank-Latin American and the

Caribbean Region. Economic Policy Sector Unit, July

2001

Choi, Kyongwook , Shawkat Hammoudeh, and Won Joong

Kim, “The Effects of U.S. Macroeconomic Shocks on the

International Commodity Prices.” Unpublished Paper

Gachet, Ivan, Diego Maldonado, and Wilson Perez,

“Determinants of Inflation in a Dollarized Economy: The

Case of Ecuador.” Cuestiones Economicas Vol. 24, No.

1:1-2, 2008

Robin, J. Ashok. International Corporate Finance

(McGraw Hill Press. 2011)

Walter, Matthew. “Ecuador Plans Spending to Reverse

Dollar’s ‘Failure’” www.bloomberg.com/apps/news?pid

Weisbrot Mark and Luis Sandoval, “Updated on

the Ecuadorian Economy,” Center for Economic policy

Research- 2009

Office of the United States Trade Representative http://www/ustr.gov/countries-regions/america/ecuador

The Effect of Dollarization in Ecuador;

http://www.mindspring.com/tbgray/dollar.htm

U.S. Department of State-Bureau of Western Hemisphere

Affairs http://www.state.gov/r/pa/ei/bgn/35761.htm

U.S. Department of State-Bureau of Western Hemisphere

Affairs

http://www.state.gov/e/eeb/rls/other/ics/2009/117668.htm

Republic of Ecuador, “Ecuador, Macroeconomic Overview,

Oct. 2009.

www.bce.fin/ec/documentos

Trade in Goods with Ecuador

http://www.census/gov/foreign-trade/balance/c3310.html

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