Official Dollarization and the Banking System in Ecuador and El Salvador

E C O N O M I C R E V I E W Third Quarter 2006 Since Ecuadorian president Jamil Mahuad announced the adoption of the U.S. dollar as legal tender in January 2000, the discussion about the pros and cons of full dollarization has intensified. In 2001 El Salvador engaged in full dollarization to enhance its economic reform process. The two economies adopted the U.S. dollar as their currency for diametrically opposite reasons: In Ecuador full dollarization occurred in the midst of an economic and banking crisis. In contrast, in El Salvador full dollarization was expected to enhance the set of previous structural reforms put in place to support economic stability and thus attract foreign investors. This article studies the evolution of the banking system in these two countries before and after the adoption of full, or official, dollarization. Under full or official dollarization, a country adopts as legal tender another country’s currency, in this case the U.S. dollar. The adopted currency takes over all the functions of domestic currency: a unit of account, medium of exchange, and store of value. The country’s policymakers thus give up any possibility of monetary and exchange rate policies. Official dollarization is equivalent to pegging the domestic currency to the U.S. dollar, but it is different from a currency board because it is irreversible. This irreversibility theoretically makes full dollarization a credible economic policy and a way to avoid currency and balance-of-payments crises. The expected benefits of full dollarization include the elimination of exchange rate risk, contributing to the decline of the country risk premium and interest rates, as well as the reduction of the inflation rate and inflationary expectations. These outcomes are expected to encourage foreign investment and a stable capital flow. One cost of full dollarization is the elimination of the government’s ability to generate seigniorage—that is, revenue from issuing domestic money—to finance its fiscal deficit. Without this possibility, the dollarizing country must look for alternative revenue sources or reduce government expenditures. By giving up control of its money supply, a full dollarization regime encourages fiscal discipline (enhancing Official Dollarization and the Banking System in Ecuador and El Salvador