Case Studies | Dollarization diplomacy: The case of Ecuador and El Salvador
The topic of monetary policy is unique in its highly technical yet equally politicized nature. A sovereign central bank and currency are closely tied to national identity and pride. Unsurprisingly, adopting a foreign currency is a challenging process not only because of a complex economic strategy but also because of the political ramifications of such a decision. For instance, short of being a currency adoption, the El Salvadoran decision to invest in Bitcoin became a global controversy. On the other hand, the U.S. dollar is the dominant currency worldwide, overwhelmingly used as the primary foreign reserve fiat. In some states, people prefer the dollar to their domestic currency because of the unmatched level of trust the dollar enjoys. Some states take a decisive step towards “dollarizing” completely. This involves a substitution of national currency for the U.S. dollar.
One may ask, what are the underlying factors behind the decision to dollarize? In ISD’s recent case study, Dollarization Diplomacy, Dr. Britta Crandall explores Ecuador’s and El Salvador’s decision to dollarize. Although they chose the same policy, their economic conditions were vastly different. When Ecuador began exchanging its currency in 1997, its economy was under severe pressure from climate disasters, spillover effects from the Asian financial crisis, and low oil prices. El Salvador, on the other hand, dollarized several years later at a time of steady economic growth, low inflation rates, and stable financial institutions.
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One crucial difference between the two nations was the presence of an apparent problem in need of a solution. Ecuador’s dollarization was a desperate way to prevent a permanent economic fallout, while in El Salvador, it was a “remedy for a sickness we didn’t have.” Still, the domestic political instability in Ecuador meant that short-term shocks were powerful enough to topple the government.
In El Salvador, the decision to dollarize was mostly grounded in personal aspirations and interests. For instance, Rafael Barraza, president of the El Salvadoran Central Bank, supported the process. He then became one of the benefactors of the transition as the future CEO of one of Central America’s largest banks.
The United States and International Financial Institutions (IFIs) responded in different ways. Ecuador’s decision received a lot of skepticism from the IFIs as they believed there were better ways out of the crisis and a firm note from the Clinton administration that the U.S. would not grant extra assistance to support the Ecuadorian government in the transition process. Since the main emphasis was on nations’ sovereignty over monetary policy, the message was clear that dollarization was not the preferred policy and that Ecuador should moderate its expectations over economic stabilization. Nevertheless, despite the low expectations and initial economic instability, the Ecuadorian economy managed to stabilize, and by 2001, annual consumer prices were lower than before the crisis started.
Dr. Crandall writes that the Ecuadorian success story has arguably encouraged other actors to pursue dollarization and gave confidence to the United States and IFIs. In late 2000, El Salvador’s dollarization bid received praise from the U.S. Treasury and optimistic comments from the IMF managing director. The transition was expected to contribute to El Salvador’s reform program and promote economic growth. Yet, dollarization failed to bring benefits comparable to the ones in Ecuador. Domestic prices rose rapidly due to the absence of accurate enough change to correspond to the original market conditions. Unlike Ecuador, the country’s interest rates have remained elevated.
Putting aside the economic implications of dollarization, the political consequences in both countries were also vastly different, and seemingly untethered to the long-term outcome of the policy decisions. Ecuador’s president, Jamil Mahuad, was forced to flee the country after his announcement of dollarization. Conversely, the El Salvadoran president, Francisco Flores, did not meet any immediate pushback despite the hasty administration of the policy. In 2014, he was accused of pocketing some $15 million in humanitarian donations during his presidency.
The case study is an example of a complex topic told through accessible language. Dr. Crandall gives enough economic background to allow people not specialized in economics to freely navigate the content and derive valuable lessons from the two countries’ experiences. It is especially relevant to students and professionals interested in monetary policy’s political and social implications ranging from domestic instability and interest groups to international mechanisms and actors involved in domestic political economy. Tied to national consciousness and routinely politicized, the sovereign currency remains subject to heated debates and lasting divisions.
The case study replicates these issues by providing discussion questions that incentivize readers to reflect upon the dollarization experiences of Ecuador and El Salvador. These questions include a recap of key terminologies such as seigniorage and currency depreciation, an analysis of different actors relevant to the case study, and a discussion of the societal consequences of the dollarization policy in both states. Despite being focused on the case study, the questions are relevant in discussing other countries’ monetary policies and their political implications.
Mikael Pir-Budagyan is a research assistant at the Institute for the Study of Diplomacy and a graduate student in the Eurasian Russian and East European Studies Program at Georgetown University.
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