Socioeconomic Implications of Dollarization in El Salvador, The
This study argues that the costs associated with El Salvador’s dollarization clearly outweigh the benefits and that the decision to dollarize was prompted not only by the need to promote economic growth, but also by the impluse to serve the interests of the financial sector and the large entrepreneurs who control the ruling ARENA party. Although the policy facilitates investment and international financial transactions, it has a negative effect on the poor by increasing inequality. To develop this argument, the authors discuss the socioeconomic and political situation in El Salvador at the time of dollarization, examine the Law of Monetary Integration, and analyze the effect of the dollarization policy on the poor.
The violent civil war of the 1980s, the heralded Peace Accords in 1992, and more recently the devastation produced by the 2001 earthquake have kept El Salvador at the forefront of international headlines over the past two decades. Less noticeable, however, has been the removal in January 2001 of the nation’s traditional currency, the colon, in exchange for the full circulation of the U.S. dollar.
International economic analysts recommend dollarization to countries that are experiencing hyperinflation as a way of bringing about fiscal and budgetary discipline. In the year 2000, El Salvador’s economy was not experiencing a crisis; but the government justified the decision to dollarize by stating the expectation that the policy would lower interest rates, increase foreign investment, and decrease transaction costs in international trade, thereby sparking economic growth. Although this predicted growth may indeed take place in the future, the data collected thus far demonstrate that El Salvador did not need such a drastic measure and that the policy is not generating the expected economic growth.
This essay will argue that the costs of the dollarization policy clearly outweigh the benefits. The rationale behind the government’s decision to dollarize therefore was not only to promote economic growth but also to serve the interests of the financial sector and the large entrepreneurs who control the National Republican Alliance (ARENA), the ruling party. This study also will argue that the policy reflects the lack of voice and influence of the lower-income groups in the political system, and that consequently, the policymakers did not consider its negative effects on poverty and inequality.
The dollarization policy illustrates a case in which a policy, although it may facilitate investment and lending and may potentially contribute to economic growth, also increases inequality by having a negative effect on the poor. Ultimately, the policy is simply a reflection of the nature of a political system which, although it is formally a democracy, continues to serve mostly the interests of a small oligarchy. What changes under the new policy is the structure of the political system and the sector of the oligarchy now served by the regime. The rest of the society remains excluded.
To develop this argument, this study will first discuss the socioeconomic and political situation in El Salvador at the time of dollarization, and then examine the Law of Monetary Integration and its implications. It will then analyze the impact of dollarization on the poor.
EL SALVADOR AT THE BEGINNING OF THE TWENTY-FIRST CENTURY
Since signing the Peace Accords in 1992 to end a 12-year civil war, El Salvador has moved steadily toward the implementation of neoliberal economic policies by privatizing the banking system, telecommunications, public pensions, and electrical services; lowering import tariffs; eliminating most price controls; and attempting to attract foreign investment through infrastructure improvements and greater enforcement of intellectual property rights (U.S. Department of State 2002, 6-11).
On a macroeconomic scale, the situation in El Salvador since 1992 has been remarkably stable. Inflation has averaged only 5 percent since 1992 (Del Castillo 2002, 5), very low for the region. Interest rates have been relatively low also, in line with Chile and pre-crisis Argentina. Compared to other Latin American countries, total external debt was manageable, at about 23 percent of GDP in 2001. Growth of real GDP has been slow but steady during the decade, ranging from 2.1 to 4.2 percent annually (U.S. Department of State 2002, 6). It is remarkable, however, that even after a decade of steady growth, real GDP per capita has not yet climbed back to the 1975 levels (see figure 1). In real terms, the economy has yet to achieve the size it had 25 years ago, before the war.
The economy is strongly tied to the United States, which receives about $1.6 billion, or 60 percent, of El Salvador’s exports annually. This close trade with the United States does not increase El Salvador’s stock of dollars, however, because imports from the United States are about $2.1 billion, resulting in a rather large trade deficit (U.S. Department of State 2002, 8). The real source of foreign exchange is the remittances sent back to families in El Salvador by approximately 1.5 million Salvadorans who have emigrated to the United States (equivalent to 25 percent of the number of Salvadorans living in El Salvador). The value of family remittances has been increasing by more than 6 percent a year for the last decade; it reached the hefty sum of $1.9 billion in 2001 (U.S. Department of State 2002, 7). This is equivalent to almost 15 percent of GDP. This flow of dollars has spawned the popular expression in El Salvador, “our greatest export is our people.”
The Salvadoran economy is dominated by the service sector, which amounts to 50 percent of GDP, while the agricultural sector produces 24 percent of GDP and the industrial sector only 20 percent of GDP.
The high remittances and the macroeconomic stability that these activities sustain hide the difficulties faced by the large majority of the population. Some social indicators are weak but improving: illiteracy is declining but remained at 21 percent in 2000 compared to an average of 12 percent in Latin America and the Caribbean (U.S. Department of State 2002, 1). The infant mortality rate has dropped consistently for three decades, from 99 deaths per 1,000 live births in 1975 to 29 in 2000 (World Bank 2000, 8).
Measures of inequality and poverty, however, tell a more alarming story of decline. Depending on the source consulted, the percentage of the population below the poverty line is steady or slightly declining but still very high, with 48 percent of the population living in poverty (CIA 2002, 7). Although the root cause of the civil was frustration with the distribution of wealth and land, indicators of inequality and real wages are actually worse now than before the war. Table 1 illustrates that the percentage of income earned by the poorest quintile continues to decline and the percent of income earned by the richest quintile continues to rise. This is true not only true for the years listed, but has been a consistent trend over 25 years.
The data also indicate that the percentage of income captured by the top 10 percent of the population equals 40.5 percent, the sixth highest in the world, while the Gini coefficient is 52.3, the fifth highest in the world (World Bank 2002).
Another important indicator of declining welfare is the constant decrease in the urban real minimum wage from 1980 to 1998. The 1998 urban real minimum wage, and thus the purchasing power of minimum wage earners, was only one-third of the 1980 value, as illustrated in Figure 2. The data on the minimum wage provide only a partial picture of the earnings situation in El Salvador, however, because about 47.9 percent of the economically active population is employed in the informal sector, which receives less than the minimum wage (Marcouiller et al. 1995, 5).
The extent to which the minimum wage influences wages in the informal sector and affects poverty has been the subject of intense debate. Catherine Saget argues, “there are indications that a higher minimum wage is associated with a lower level of poverty” (Saget 2001, 20). Privatization of services has also led to decreasing purchasing power among low-wage earners. Telephone services were privatized in 1998, and charges have increased 37 percent since 1999. Electricity was privatized in 1992, and prices have risen 221 percent over the last decade. Water service, not privatized, has also seen a 33 percent increase in cost over the last three years. Data from 2002 indicate that the cost of these three basic services amounted to 41 percent of a minimum wage earner’s salary (Medrano 2002).
The Political Environment and the Decision to Dollarize
The abysmal social inequality is clearly reflected in and perpetuated by the political system in El Salvador. Today, that system recognizes both ends of the political spectrum, the oligarchy represented by ARENA and the lower-income groups represented by the Farabundo Martí National Liberation Front (FMLN). The current democratic system, however, has simply legitimated the social polarization that has existed in the country since independence. This polarization created the conditions for the great massacre of the 1930s and the civil war in the 1980s.
Formally, El Salvador is a presidential democracy. Power is divided among the executive branch, led by a president elected directly by the people; a legislative branch, consisting of an 84-member unicameral Legislative Assembly; and an independent judiciary. ARENA and its conservative allies have been in power since 1989, controlling both the presidency and the Legislative Assembly (in coalition) for 15 years. In March 2004, ARENA won the most recent presidential elections to maintain executive power for an additional 5 years under the new direction of Tony Saca. The party also holds 27 seats in the legislature, which, along with the National Conciliation Party’s (PCN) 16 seats, makes the conservative coalition the legislative majority.1
In recent years, ARENA has become divided into two factions: one representing the traditional agricultural wealth and influence, and the other representing the new power of the rising financial sector. The agricultural and financial sectors often have conflicts of interest, with the former preferring nationalistic strategies geared to obtain government subsidies and protectionist policies, and the latter pushing for the establishment of an open economy, access to foreign investment, reduction of trade barriers, the development of maquiladoras, and tourism (Petras 1997). The power of the old traditional sector has declined, given its association with the war and human rights abuses of the 1980s and also the international pressure on the government to adopt free market policies.
President Francisco Flores (1999-2004) and his associates represent the preeminence of the new oligarchy. Their power is clearly reflected in their decision to dollarize the economy (Proceso 2000a, 2001, 2003). This new oligarchy is represented by the National Association of Private Entrepreneurs (ANEP), which functions as a satellite of the ARENA party. The two have a symbiotic relationship, according to which ANEP acts as a defender of the party’s decisions while ARENA adjusts its decisions to the interests and aspirations of the main sectors ANEP represents; these include the financial and manufacturing sectors (Proceso 2002b, 8).
The crisis and transformation of the ARENA party can be traced back to the electoral disaster of 1995. Former President Alvaro Cristiani was challenged and ultimately had to relinquish control to a younger generation of leaders representing the interests of the financial and import sectors of the economy (Proceso 2000b, 8). Most important, “the decision to dollarize took place at a time of discussions and negotiations within the national political class [Arena]. The decision was not the result of a consultation process with other political actors. . . . Thus, in spite of the rhetoric, President Flores has not abandoned ARENA’S typical authoritarianism” (Proceso 2000b, 5, 6). Several analysts argue that the decision to dollarize was taken because of its political and not its economic implications, because the country was not experiencing hyperinflation (Proceso 2000b, 14). Analysts have also highlighted Flores’s authoritarian personality and his tendency to make decisions without consultation or national discussion (Proceso 2002b, 6).
Given ARENA’S strong hold on political power and the new power of financial sector figures within ARENA, it should be no surprise that a dollarization policy with the banking sector as its primary beneficiary would be proposed and approved. A University of Central America document states, “The most benefited sector from the dollarization process has been the financial system, which no longer faces the risk that its payments will be increased from possible devaluation decided by the political circles” (Proceso 2002a, 8). It is in the financial sector’s interest to dollarize, so that if any opposing political party gains power or if the financial sector otherwise loses its political influence, financial policy can barely be altered.
Opposition to dollarization was widespread among the population, and recent surveys indicate that the opposition continues. A survey conducted by the Instituto Universitario de Opinion Publica on the performance of the Flores administration during its third year showed that only 2 percent of the population considered dollarization an achievement, while 62.2 percent believed that dollarization had been damaging to the country’s interests (ITJDOP 2002, 1-3). The opposition movement did not make much impact, however, because protests were cancelled and attention diverted by the devastating earthquake (7.6 on the Richter Scale) only 13 days after the start of dollarization. A comment from a community organizer expressed the frustration of the would-be protesters: “Even God is against us. The day that the most enthusiastic protests were planned, the earthquake came.”
The U.S. government played a subtle role in the decision to clollarize. Federal Reserve Board Chairman Alan Greenspan has declared that the U.S. government “will not actively encourage or discourage another countiy from clollarizing” (Furstenberg 2000, 108), while former Treasury secretary Lawrence Summers welcomed the decision in a comment made within an hour of El Salvador’s announcement (Elton 2000, 2, 3). Benefits to the United States are small; they include slightly increased seigniorage earnings, reduced costs for U.S. transactions with dollarized countries, and the “power and prestige” that come with the international use of the dollar (Truman 2000, 2, 3). Costs are also small, and take the form of hypothetical situations: there could be negative consequences if dollarizecl countries exert pressure to change U.S. monetaiy policy to benefit their countries, if economic instability in dollarized countries results in blame and resentment toward the United States, or if several large countries dollarize and reduce the monetary flexibility in the United States (Truman 2000, 3). Overall, the Salvadoran economy is so small compared to that of the United States-only $13.2 billion annual GDP compared to the U.S. $9.8 trillion GDP in 2001 (World Bank 2002)-that the dollarization policy does not appear to have any major U.S. impact.
If ARENA and its coalition represent one pole on the political spectrum, the FMLN stands at the other extreme. Compared to armed opposition groups in other countries that have tried to integrate into the political system, the FMLN has been very successful. In the 2000 legislative elections, the party won 31 seats, the greatest number won by any single party, and party members hope to be extremely competitive in the 2004 presidential elections. Because the FMLN has never held the presidency or controlled an effective majority in the Legislative Assembly, however, its policymaking power is very limited. Over the last decade of political participation, furthermore, the FMLN has lost touch with the struggles of the poor communities. According to Petras, the FMLN “has lost its class identity and revolutionary character” (1997, 3). Internal conflict has also afflicted the FMLN; in 2002 a section of the party broke off and formed the Renewal Movement, which held five seats in the legislative assembly until those seats were lost in the 2003 legislative elections. Thus, although the party fervently opposed clollarization, its votes were not enough to defeat the policy.
The low voter turnout-39 percent of eligible voters participated in the 1999 presidential election and 35 percent in the 2000 Legislative Assembly elections (U.S. Department of State 2002, 3)-makes clear that the people clo not expect very much from the political system. Indeed, in an opinion poll of 1,223 adults conducted by the Central American University in May 2002, 64 percent of respondents said that the government had responded little or not at all to the demands of the population, and 84 percent said that they had benefited little or not at all from the Legislative Assembly. The same poll showed an even larger degree of dissatisfaction when respondents were asked what party they would vote for in the 2004 elections. The winner was “no party,” with 29 percent of responses (IUDOP 2002, 5).
Thus the democratic political structure contains the same political and socioeconomic divisions that have always existed in El Salvador. The system has excluded the poor and concentrated power in the hands of a small elite. Two things have changed, however: violence has subsided, and the sector of the elite that is now in control has changed, as the new financial and import sectors have replaced the old landowning oligarchy.
THE LAW OF MONETARY INTEGRATION
Dollarization first emerged as a policy idea in the mid-1990s, but it was not implemented until 2000. In November 2000, President Flores announced his administration’s decision to dollarize the economy. The Legislative Assembly passed the law less than one week later, despite FMLN opposition. Dollarization was implemented on January 1, 2001, only 39 clays after the president’s announcement of the policy.2
The Economic Implications: Costs and Benefits
According to Stanley Fischer, Deputy Managing Director of the International Monetary Fund, “the argument for dollarization relative to a currency board turns on an appraisal of the gains from dollarization that would be obtained in the capital markets, versus seigniorage costs and the value of retaining the option of changing the exchange rate in extremisby retaining a national currency” (Fischer 2001, 18). No public discussion of the economic costs and benefits of dollarization took place before President Flores announced the Law of Monetary Integration, and very little took place afterward. In his speech, Flores argued that the adoption of the dollar was going to generate economic growth by producing a decline in interest rates and an increase in foreign investment. In the speech, he briefly addressed the resulting need for fiscal responsibility, but he did not go into detail. The president’s speech told only part of the economic story; it failed to address most of the complexities and disadvantages of the policy.
The predicted benefits and costs of dollarizaton are summarized in tables 2 and 3. The National Foundation for Development (FUNDE), a nongovernmental organization geared to promoting economic debate, analyzes the decision to dollarize as follows:
On one hand, some of [the benefits] such as the declining interest rates either were already occurring or could have been achieved without the need of such a drastic macroeconomic shift. On the other hand, some benefits (again, such as the new decline in interest rates) will be visible in the short term, but the current situation and structure of our economy give little guarantee of their continuation in the medium to long term. (FUNDE 2002, 2)
Dollarization may be the only option in a case like Ecuador, which dollarized in January 2000 as an attempt to control an enormous economic crisis. Inflation had increased from 25 to 30 percent in 1996-97 to 6l percent in 1999; the real effective exchange rate had depreciated by almost 50 percent in 1999 (IMF, 2000); and a liquidity crisis had led regulatory authorities to intervene in or freeze 65 percent of onshore bank assets in the 18 months before dollarization (IMF 2000). But El Salvador faced none of these dire circumstances. Indeed, El Salvador does not fulfill the requirements for dollarization, which include a flexible labor market; the inability of the Central Bank to control inflation because of populist pressures; a very small economy, in which prices are already fixed in dollars; and close links to the U.S. economy (Sachs and Larraín 2000, 237, 238). Although the U.S. and the Salvadoran economies are closely linked, the policymakers could have found more effective means to attract foreign investment and lower interest rates.
Most economists agree that the potential benefits of dollarization are to control inflation and interest rates, to increase investor confidence, and to reduce transaction costs. With the use of the dollar, inflation tends to stay low, assuming that inflation in the U.S. stays low; and low inflation helps keep nominal interest rates down. Inflation, a major problem in many Latin American countries, was very moderate in El Salvador, averaging only 5 percent during the last decade (Del Castillo 2002, 5). In the future, the level of inflation will depend on the rate of inflation in the United States, which introduces a new type of vulnerability into the Salvadoran economy.
The adoption of the dollar as a national currency entails loss of control over the value of the currency, which might be highly desirable if the country’s currency is constantly fluctuating because of inflation. This, however, was not the case in El Salvador, where the exchange rate had been stable at 8.75 colones per dollar since 1994. For better or worse, the adoption of the dollar will entail dependence on the monetary policy followed by the United States. For instance, the decline of the value of the dollar in regard to the Euro in 2003 should help Salvadoran exports, but it is likely to produce inflation. Adopting the dollar also entails increased access to external credit in dollars, which could stimulate domestic spending to outpace productive capacity in nontradable goods and services. Prices of tradable goods would be restrained as long as trade is open, but dollarization does not guarantee the price stability of nontraclables.3
The use of the dollar will also produce a convergence of interest rates and the automatic adoption of the rates existing in the United States. This process will allow domestic banks to attract foreign credit, facilitating the expansion of credit, investment, and consumption. Nominal interest rates in El Salvador, however, were among the lowest in Latin America, as illustrated in figure 3. In addition, nominal interest rates were already declining steadily before dollarization, from 19.42 percent in 1993 to 13.46 percent in 2000 (IMF 2002). It is important to note that although interest rates may continue declining as a result of dollarization, the decline will have a direct and immediate benefit only on the financial sector and upper-income groups, because formal loans are not available to the majority of the population; their credit sources typically are NGOs or loan sharks in the informal market. Lower-income groups will benefit only if the low interest rates generate added investment, which, in turn, will generate job creation and rising incomes; and if the financial system proves to be flexible and capable of expanding. Thus, if the liquidity of the formal financial sector increases significantly, it will be easier for those involved in the informal lending sectors (that is, NGOs, charitable institutions, and individuals) to expand their lending, which, in turn, should contribute to investment and employment in the informal sector of the economy.
Low inflation and interest rates, along with the elimination of the risk of devaluation, serve to attract foreign investment. In El Salvador, however, the investor risk has not significantly changed with dollarization. Standard and Poor’s, for example, has raised ratings for El Salvador slightly since January 2001, but continues to give the countiy an average investment credit rating. In their assessment, Standard and Poor’s analysts consider dollarization, along with macroeconomic stability and widespread structural reform, to be a positive feature for the country. On the other hand, weak public finances, low savings, pervasive poverty, and public insecurity made investment in the country riskier, and will continue to deter investors even with a dollarization policy (Del Castillo 2002, 1, 2). Direct foreign investment, especially in the form of maquiladoras, has the potential of generating additional jobs and economic growth. Ultimately, increases in foreign investment will be linked to increases in productivity, which will require investments in education and job training.
Another benefit that follows from the use of the dollar is lower costs in international transactions, because there is no need to buy and sell currency and accounts are kept in only one currency (Naranjo 2000). Lower transaction costs are one of several factors which may increase foreign investment and facilitate imports and exports. The financial sector is a direct beneficiary of the policy because of its involvement in international transactions.
Dollarization will also potentially allow the large financial groups to expand their operations to other Central American countries because they will be able to move the low-interest loans obtained in El Salvador to countries with a much higher interest rate.
Absent from the political discourse about dollarization in El Salvador were the drawbacks and risks. The negative effects generally attributed to dollarization are loss of seigniorage earnings, loss of monetary policy control, loss of the central bank’s ability to be the lender of last resort, associated liquidity problems, transition costs, and loss of a national symbol (Sachs and Larrain 2000, 237-38).
Seigniorage refers to the earnings the government makes by printing money and selling it. The government earns the difference between the intrinsic cost of the money plus the costs of printing, and the money’s acquisition power. By giving up the power to print its own money, the government incurs a loss equivalent to the annual amount of money that it would have printed. Seigniorage in El Salvador, together with loss of interest from net international reserves because of withdrawal of dollars from circulation, is estimated to amount to a loss of 1.3 percent of the GNP annually (Proceso 2002a, 7).
Dollarization also takes away the central bank’s power to control monetary policy. The government can no longer finance budget deficits by issuing currency. Nor can it adjust the exchange rate to act as a shock absorber for the economy or to compete effectively in the export market. If the exchange rate cannot be adjusted, the country’s competitiveness in the short run can be improved only through a reduction of prices and wages, which will lower the price of the exports (Sachs and Larraín 2000, 228-41). Reducing prices and wages has led to economic crises in several countries with pegged currencies, including Brazil, Russia, South Korea, Thailand, and Argentina. There is no question that competitiveness could be increased in the medium and long run through a variety of means, including improvements in education, technical training, and product quality, and access to new markets.
With dollarization, the Central Bank also gives up its ability to act as the lender of last resort. It can no longer finance loans to banks in case of a liquidity crisis because it cannot print money (Chang 2000, 1). Without this backup for liquidity, banks’ reserve assets will depend on the flow of incoming foreign currency (Calcagno and Manuelito 2001). In the short term, El Salvador may not be at risk of a liquidity crisis because of the nearly $2 billion flow of remittances sent annually by SaIvadorans living in the United States.
The costs of transition to clollarization include adapting bank accounts, cash registers, and accounting systems to the new currency. More important, the dollarizing country incurs a stock cost, or the cost of purchasing the first set of bills and coins needed for circulation (Bogetic 2000, 4). El Salvador’s stock cost was approximately 2.1 percent of GNP, or $330 million removed from the net international reserves (Proceso 2002a, 7).
In the medium and long run, dollarization will create new fiscal pressures. It is likely that low interest rates will have to be sustained with added government financing, which will not be easily compensated given the rigidity of the tax system. The government probably will have to reduce other spending in order to finance dollarization (FUNDE 2002, 2, 3).
Losing the symbol that is the national currency has psychological effects. A currency printed with national figures is a source of national pride and conveys to the public the perception that the government is capable of running its own monetary policy.
Assessing the Salvadoran case
Dollars quickly began flowing through El Salvador’s economy in early 2001. The Central Reserve Bank reported in June 2002, 18 months after the Law of Monetary Integration took effect, that the Salvadoran economy was 98 percent dollarized. Ninety percent of that change occurred instantaneously, as Salvadoran stocks of U.S. dollars were taken out of reserve and put into the financial system (Rodríguez 2002). Circulating currency has been slower to change, as would be expected. In June 2002. 74 percent of circulating cash was in dollars, an equivalent of $370 million (Rodríguez 2002). The Central Bank of El Salvador estimated that almost 90 percent of the colones would be replaced by the end of 2002 and that the process of replacement would be completed before the end of 2003. “The process of clollarization of the economy will not be fully concluded until the Ministry of Finance establishes a timetable for the definitive transference of the Central Bank debt (about 5 percent of GDP), which will allow the Central Bank to ‘clean’ its account balances” (Rodriguez-Balsa 2002, 7).
Considering that the policy has been in place only for two years at this writing, we can look only at its short-term impact. We therefore will focus on its impact on interest rates and economic growth.
Although El Salvador’s interest rates were already dropping steadily before dollarization, the new currency apparently has encouraged a further decline. Nominal rates fell from 10.6 percent in 2000 to 7.8 percent in 2001 and 7.1 percent in 2002 (figure 4). In real terms, rates declined from 6.6 percent in 2000 to 3-9 percent in 2001 and 3-4 percent in 2002 (Rodríguez-Balza 2002, 10). The decline in rates may be caused partly by dollarization and partly by the poor performance of the economy in the last two years.
During the 12 months 2001-2, private sector credit did not increase as expected but actually fell by 3.4 percent between 2001 and 2002. As a result, the Salvadoran banks are expanding their operations to other Central American countries. By July 2002, lending in the region had increased at a rate of 66 percent per year (Rodríguez-Balza 2002, 5).
Another potential benefit, increased foreign investment, has not shown significant results, given that investment ratings, such as those of Standard and Poor’s, have not changed much because of dollarization. Rates of new investment have increased only slightly, and were already rising before dollarization. Net foreign direct investment rose from 12.7 percent of nominal GDP in 1999 to 13.7 percent in 2000. The estimate for 2001 was 14.6 percent and for 2002, 14.3 percent (Del Castillo 2002, 18).
If the ultimate goal of dollarization is to increase economic growth, the policy has not yet produced much of a result. The GNP growth rate in 2000 was 2 percent, 1.8 percent in 2001, and was estimated at below 2.0 percent for 2002. Growth for the first six months of 2002 was 1.7 percent, the lowest growth in five years (Rodrínguez-Balza 2002, 1). Several factors explain the low growth rate, including declining international trade, competitiveness problems in the Salvadoran economy, and the recession in the United States. Still, for whatever reason, the predicted growth resulting from clollarization has not happened. It is clear that external factors play a strong role in determining the amount of economic growth in an open economy and that dollarization is just one of many factors that affect economic growth. Also clear, however, is that the dollarization policy has not attracted the amount of foreign direct investment required to generate added growth, mainly because other factors, including high rates of poverty and violence and the lack of infrastructure, have outweighed its positive influence.
Both imports and exports declined significantly during 2002. Traditional exports, such as coffee, sugar, and shrimp, declined by 30.4 percent between 2001 and 2002, while the nontraditional exports and the maquila exports increased at a slower rate than in the previous years (about 3 percent in 2002 and 5.2 percent in 2001). Imports of capital goods and intermediate products declined by 9.4 percent and 7.3 percent, respectively, while consumer products increased by 8.8 percent in 2001 and only 6 percent in 2002. The government continued to rely on remittances to cover the deficit in the commercial accounts. The remittances increased by 5 percent between 2001 and 2002 (Rodríguez-Balza 2002, 3, 4).
One cost the Salvadoran government absorbed was the transition cost. The initial stock cost to remove dollars from international reserves and place them in circulation was $330 million, or 2.1 percent of the GNP. An additional annual cost is the loss of interest revenue from the dollar reserves, equivalent to 1.3 percent of GNP (.Proceso 2002a, 7).
Relinquishing control of monetary policy has had unpredicted effects for the government. El Salvador’s budget deficit rose to 3.7 percent of GDP in 2001 as a result of the January earthquake. With no ability to influence monetary policy, the government had to choose between borrowing funds or cutting the budget. Lacking sufficient international financing, the government chose to cut ministerial budgets by 17 percent in 2002 (Economist 2002, 34). These cuts have resulted in a reduction of social services and programs, with a predictably negative impact on lower-income groups.
In the short run, Salvadoran policymakers must contain pressures to increase workers’ salaries until the country becomes more competitive and capable of exporting products with a larger value added, including those a greater high technology component. To make dollarization a viable policy, the government will have to maintain a rate of inflation no higher than 3 percent and a budget deficit lower than the expected 3.8 percent for 2002. Imports should grow at no more than 3 percent, while exports should grow at a much faster rate (Rodríguez-Balza 2002, 8, 9).
DOLLARIZATION’S IMPACT ON THE POOR
To understand fully the effects of dollarization on the poor, the macroeconomic data need to complemented with a more specific analysis. A relevant vehicle for such an analysis is the impact of dollarization on microbusinesses.4 According to Maria Eugenia Ochoa, an economist at FUNDE, Salvacloran microbusinesses provided 512,000 jobs in 1999, far outweighing the 90,000 jobs from maquiladoras (Ochoa 2002). Eighty-five percent of microbusinesses in El Salvador are subsistence-type businesses, meaning that the owners are making barely enough money to cover their needs. The data also indicate that about 75 percent of the owners of microbusinesses do not even make the minimum wage. Thus, comments from the microbusiness owners interviewed in this study are likely to be similar to the attitudes of a large portion of Salvadorans.
Interviews were conducted with 36 people (21 women and 15 men) between June and August 2002. Ranging from 23 to 70 years of age, the participants came from 6 different communities, including a rural community about one hour from San Salvador; a semiurban community in the outskirts of San Salvador; a fishing village on the southern coast; a remote rural community in the southern part of the country; a semiurban area on the outskirts of Santa Ana, the second-largest city; and a remote rural town in the north. Twenty-one of the subjects were small vendors of tortillas, clothes, and basic foodstuffs; 9 were rural agricultural workers; and 6 depended on another family member for income. Their educational level varied from informal to some high school, and their income rarely exceeded the minimum wage.
The Salvadoran elite argues that the population has welcomed dollarization with open arms. For instance, a leading newspaper reported in June 2002 that “the acceptance of the dollar by the population has been such that the monetary authority estimates that by December of this year, between 85 and 90 percent of the circulating money will be in United States currency” (Rodríguez 2002, emphasis in original). Jorge Alfaro from the National Commission for the Micro and Small Business (CONAMYPE) expresses the same idea.
Some have accepted it because they prefer the dollar, with logic, with analysis. Others have accepted it because maybe they don’t have another option. Maybe in the first months there was some type of resistance, but more of an influenced resistance, influenced by those who oppose the use of the dollar. In the end, the population was very adept. (Alfaro 2002)
It is important to distinguish between accepting the dollar and benefiting from the dollar. Some of the opinion polls and interviews have focused on that distinction and have produced different results. In a public opinion poll carried out by the University of Central America among 1,223 adults in May 2002, 61 percent of the respondents reported that dollarization has had a negative effect on their personal economic situation, and another 22 percent said that it had not changed their situation (IUDOP 2002, 3). Our interviews also revealed this sentiment. One interviewee stated, “If I thought that the dollar would bring me some benefit, if it was going to change my lifestyle, I would be more willing to know how to better use the dollar, but if not, I prefer my money.”
It therefore seems that the swift expansion of dollars in the economy occurred simply because the population had no other choice, rather than because the population willingly accepted the dollar. It further seems that resentment toward the dollarization policy is not an ideological issue, but instead results from the negative economic and psychological impact produced by the change of currency. We can identify at least four factors in this situation: the lack of information during the transition and orientation period; greater inflation produced by the “rounding up” of prices when the conversion to the dollar took place; the lack of benefits from the lowering of interest rates; and a sense of vulnerability and political frustration.
Transition and Orientation
Thirty-nine clays after President Flores announced his desire to dollarize, the new currency began to arrive in the hands of the population. This was certainly a very abrupt and sudden change, which gavethe society no time to learn about the new currency. Currency reform requires a great deal of time and effort on the part of the government; for instance, the member countries of the European Union spent about three years educating the population before the Euro was introduced. By contrast, not much was done in El Salvador.
Interviewees emphasized that no information or orientation came from the government or any other organization to educate them on the use of the dollar. Most had to rely on diagrams printed in the newspaper illustrating the value of bills and coins. Others used small printed conversion tables or invested in a calculator. As several people pointed out, none of these methods was effective for the 21 percent of Savadorans who cannot read or write, much less multiply and divide by 8.75 (the rate of conversion).
Jorge Alfaro of CONAMYPE explained that his government-associated organization conducted a survey during the first week of dollarization to identify difficulties that small business owners were facing with the use of the dollar. The intention was to provide solutions; but this process, like many others, was interrupted by the January 13 earthquake. In the end, CONAMYPE’s only response was to distribute about ten thousand conversion tables. “There was really nothing else to help the people during the change,” Alfaro said (2002).
In all the communities surveyed for this study, the majority of transactions now take place in dollars. Even in the remote rural communities, respondents reported that 80 or 90 percent of the money they handle is in dollars. Closer to the capital, respondents reported nearly 100 percent in dollars. Yet even 18 months after the policy began, 59 percent of the participants mentioned that they still did not understand the value of coins or bills and had trouble with monetary transactions. This is especially true for the less educated; one respondent said, “There are people who could not study, and it affects them more. They are more disoriented than anyone, and others can cheat them.” A survey by the Central Bank of El Salvador (with unknown number and characteristics of participants) found that at the beginning of monetary integration, about 55 percent of those surveyed did not understand how to use the dollar; but 18 months later, only 20 percent reported difficulty (Rodríguez 2002). The difference in results between that study and the one for this article probably results from different sampling populations.
It is clear, then, that proper information and orientation were not provided to the public. The results were confusion, frequent errors, or purposive cheating in monetary transactions. While people who handle money frequently have learned the value of dollar bills and coins, many others still report difficulty.
Inflation from Rounding Up
A second impact of clollarization on the poor is greater inflation, because of their distinct purchasing patterns. María Eugenia Ochoa of FUNDE points out the need to look beyond low aggregate inflation rates to see greater effects on the poor.
This has been the great success of the Salvadoran government under the ARENA administration-to have controlled inflation…. How is it, then, that the people say that it doesn’t fit [with their experience]? What happens is that in the averages and generalities of the economy we lose the particulars. The prices of cars and real estate haven’t gone up, but within the average you also have all the price increases in rice, beans, and sugar. The [rise in cost of] basic consumption goods are lost in the aggregate. (Ochoa 2002)
Our interviews confirm what Ochoa indicates. Aggregate inflation continues at a low level, about 3.8 percent in 2001 (CIA 2002, 7), but when asked about prices since dollarization, 65 percent of participants responded that prices have risen because they are rounded up when converted to dollars. Because the exchange rate was 8.75 colones to one dollar, a round number in colones does not translate into a round number in dollars, so the prices in dollars are rounded up. The effects of rounding up differ in the formal and informal sectors of the economy, and consequently they affect the rich and the poor differently. According to the Law of Monetary Integration, businesses are not permitted to increase prices in dollars over what they cost in colones. Thus, in the formal market, prices are rounded up to the next cent, and inflation from rounding up is minimal. In the informal market, where the poor operate, the situation is entirely different. First, there is almost no regulation, so vendors have often set prices in dollars much higher than what they were charging in colones. One participant observed, “some people take advantage of the change, and for what used to be seven colones they now charge a dollar.” From seven colones to a dollar is 25 percent inflation.
Second, even when the conversion is done correctly and the prices in dollars are set at the next cent, the poor often buy in very small quantities, creating a greater inflationary effect. Instead of a trip to the supermarket to purchase 30 dollars’ worth of goods for the week, those with fewer resources visit the comer store several times a day to purchase one colon of tomatoes, later two colones of tortillas, and again for a colon of detergent. One colon is exactly 11.4 cents in dollars, so they are charged 12 cents. Two colones equal 22.8 cents, so they are charged 23 cents. The one-colón transaction has now experienced 5 percent inflation, and the two-colón transaction 1 percent inflation. For families living on a few dollars a day, these price increases are significant. One rural agricultural worker clearly understands this effect.
In reality if they put a price exactly in dollars after converting it from colones, they are either going to charge us two cents more or they are going to lose two cents. So we have to see that it is usually the consumer who is going to lose, because he or she will have to pay those two cents. That is how we are affected.
For this reason, by far the most frequent complaint by interviewees about dollarization, mentioned by 83 percent of participants, is the difficulty in giving change. One person commented, “In the market either you rob people [of those cents] or they rob you. It causes conflict because they fight for one cent, or else they give me dollars and they want change in colones.” Those who bear the extra cost are final consumers, who always pay the inflated cost. Jorge Alfaro from CONAMYPE observed this effect: “the prices have risen for the final consumer, because the ones who sell in the transaction protect themselves. When [the seller] buys, he or she has to pay the extra. The ones affected are those who do not transfer” (Alfaro 2002). The vendors also supported this view, saying that they are not the ones who suffer most from the rounding-up effect because they purchase goods for their business at a slightly inflated cost, but also sell their products at a slightly inflated cost.
The main argument used by the government to promote dollarization was that interest rates would be reduced, but the poor have not benefited from the lower interest rates. Only one interviewee acknowledged that interest rates had fallen slightly on loans that he takes from the bank. Sixty-seven percent of the participants were recipients of credit from one microcredit organization, and their interest rates had remained the same after dollarization. The rest of the respondents either did not receive credit or had not seen their interest rates change.
These results are fairly typical of the effects of dollarization on the low-income population. People with scarce resources rarely get loans from banks. Maria Eugenia Ochoa asserts that 70 percent of the credit in the country is lent by four banks, and loans to four hundred clients represent 60 percent of the credit borrowed. Thus the number of banks lending is limited to a small group of borrowers. According to Ochoa, the remainder of the population does not have access to bank credit. Many people turn to nongovernmental organizations that work specifically with the poor population and charge interest rates ranging from 30 to 48 percent annually, or turn to money lenders who lend at a rate between 50 to 150 percent (Ochoa 2002). Interest rates for these alternative lenders are likely to evade the influence of the financial markets, and therefore the poor have yet to see interest rates decline because of dollarization. Some agencies, such as the Social Fund for Housing, offer low-income people loans from within the formal financial economy, and here interest rates have declined; but the loans come only with an associated extension of time of payment, which in turn increases the cost of the loan.
It is likely that the poor will benefit from the reduced interest rates only if the rate reduction increases investment and jobs, or if the informal sector of the economy becomes more permeable and the lower rates in the formal sector end up reducing the rates charged in the informal sector.
What appears to be most striking psychological effect of the dollarization policy is the increased sense of vulnerability among the public. People feel less comfortable with the money they are using and feel that they can be easily cheated. For instance, when asked how dollarization had affected them, 35 percent of interviewees said that they were being robbed in their transactions. A sense of vulnerability also comes from knowing that falsification of dollar bills has increased dramatically. Several participants said they had received a counterfeit bill, which cost them a large amount of money. Many interviewees also demonstrated a new lack of self-confidence: “I can’t do it [handle transactions in dollarsl.” “I don’t understand the dollar.” “I don’t have the education to know how to multiply.” These were commonly spoken expressions of the frustration produced by the policy.
Other respondents expressed a sense of loss of a cultural symbol. A microcreclit promoter said that losing the colon was “losing the identity that we have as a people. There should be a different currency for each culture to reflect the idiosyncrasies of each culture.” The feeling that the colon somehow represented them was commonly expressed indirectly when participants referred to the colon as “ours,” “the Salvacloran money,” or “mine,” as opposed to the dollar.
Still, the resilience of the Salvadoran people is tried and true. This is not the first time they have had to adapt to a situation they did not choose for themselves. Several interview subjects stated, “It was hard in the beginning, but now we are getting used to the idea.” While vendors and those who handle many monetary transactions daily were particularly quick to learn to use the dollar effectively, the uneducated-that is, the majority of Salvaclorans-felt quite lost.
The political process by which clollarization was approved demonstrates clearly how the population’s desires are not reflected in policymaking. In the interviews, all but one participant expressed the view that the government’s decision to dollarize had worsened their economic situation. On the other hand, the wealthy business community has declared that dollarization has been beneficial. At an ANEP gathering of 585 businesspeople from various commercial sectors, convened to offer economic advice to the government, a poll showed that 94 percent of association members agreed that the Law of Monetary Integration was a good policy (Malclonado 2002).
The Salvadoran majority is well aware of and frustrated with its powerlessness to influence policy. One interviewee stated, “They [the government] didn’t ask the people if they agreed,” Another said, “as always, the government makes its decisions listening to the people who are closest, who have voice, and not to the great majority, who cannot even give their opinion.” Popular opinion holds that dollarization is one more policy to benefit the wealthy. When asked if they thought the upper class benefited from dollarization, one hundred percent of interviewees said yes. One respondent said, “Now for the rich the dollar works well; he who has more will now be helped more. They know very well how to work us even for fractions of a cent.” Another said, “The upper class has benefited, they never lose even a cent.” A newspaper editorial also expressed this idea.
The Salvadorans now are waking up from the sweet dream of the green (synthetic) pasture, that-by pure force-as the hungry say, without being consulted, was arranged for the picnic of the same ones as always, of those who always rest and eat; travel and eat; squander and eat; exploit, rob, swindle and eat. (Lopez 2002)
Most interviewees had less to say about any symbolism in that the new currency comes from the United States. One such comment was, “using the United States’ money does not have much relevance. It’s just money, the same as long ago when they just used seeds.” A few, however, saw imperialistic symbolism in the use of the dollar. “The United States has bought us”; “We are now governed by the United States.”
The decision to clollarize is often associated with deep economic crises that demand a drastic readjustment of the economy, a reduction of inflation, and the need to control exchange rates. What is interesting about the Salvadoran case is that the decision to dollarize was not the result of a crisis and that the country was not experiencing hyperinflation. It is also clear that there was no public discussion of the costs and benefits of the policy.
From the analysis presented in this study, it appears that in the Salvadoran case, the economic costs outweigh the benefits. The effects of the policy can be discussed from four different perspectives: political aspects, effects on the government budget and fiscal policies; impact on economic growth, and effects on the different socioeconomic groups.
From a political standpoint the policy appears to be reflection of El Salvador’s polarized political and socioeconomic system, the power of the financial sector of the ARENA party, and the very limited influence of the opposition represented by the FMLN.
Dollarization means lack of control over monetary policy, which, in turn, means that when the government has a budget deficit, it has no choice but to cut spending. It no longer can use its control over the exchange rate to promote exports. In times of crisis, monetary policy cannot be used as a shock absorber. If remittances decline and a liquidity crisis follows, the government will not be able to bail out banks or insert currency into the economy. The dollars removed from the national reserve and put into circulation, furthermore, cost $330 million, and the government will continue to lose money in the future because of lost interest on that reserve.
Dollarization may contribute to small increases in economic growth through lowered interest rates. The proponents of the neoliberal model promise that economic growth will eventually raise the living standards of all the people. As shown in this paper, however, clollarization in El Salvador has not yet increased economic growth.
For the poor, the policy has uniquely negative effects, including inflation from founding up prices, as well as a sense of confusion and vulnerability. To the extent that the poor have no access to formal loans, they have not yet benefited from the decline in interest rates, the most positive effect of the policy. The financial elite, on the other hand, does benefit from the lower interest rates and from the elimination or reduction of transaction costs.
Possible Gains for the Poor
While it is clear that the adoption of the dollar has produced a negative effect on the poor, there is one ray of hope in the medium and long term. If followed by gains in productivity, dollarization should attract foreign investment and thereby generate jobs and increased earnings. It will be essential then for the Salvadoran government to pursue policies geared to improving productivity, especially by investing in education and job training.
It will also be important for the government to pursue policies geared to expanding access to credit in order to expand the positive effects of the policy to the lower-income groups. Ideally, the government should guide at least a part of the new foreign investment into jobproducing activities and away from strategic alliances with the Salvadoran financial sector. If capital goes only to the financial sector and is used mainly for speculative purposes, the policy will not only fail to generate any positive effects on the poor; it will reinforce the existing distribution of income and power.
1. When the legislation approving dollarization was passed in 2001, ARENA held the presidency under Francisco Flores and held 29 seats in the legislature; the PCN held 14 seats.
2. A distinction should be made between informal dollari/ation and official dollarization. Some writers consider many countries in Latin America to be dollarized because of an abundance of U.S. currency flows in the country’s financial market. This unofficial use of the dollar is informal dollarization. In this paper, however, the term dollarization refers to full or official dollarization, which has been adopted only by El Salvador in 2001, Ecuador in 2000, and Panama since its occupation (Schuldt 1999, 10, 11). In full dollarization, the circulating national currency is replaced by the dollar.
3. The authors are grateful for the suggestions made here by one of the reviewers. We have incorporated many of them into this section.
4. There is no standard definition of a microbusiness (microempresa) but most institutions define it by number of employees (common definitions specify up to either five or ten employees) and annual income (commonly up to US$150,000 or US$1,000,000). Microbusinesses referred to in this paper have between one and five employees and net annual income of less than $20,000.
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