Ecuador after the Financial Crisis: Room for Internal or External Policy Space?

Diana Tussie

Paul Krugman has drawn attention to the plight of Ecuador, noting that, since the country does not have an exchange rate policy (and hence a monetary policy), it stood deprived of a variety of policy instruments to face the crisis. With tied hands it resorted to the expedient of restricting imports.

Dollarization was no doubt a straightjacket. Ecuador nonetheless worked against the current and found policy space in a two pronged strategy to strengthen the financial system under threat of runaway deposits; and to provide support for domestic agriculture and industry.

Soon after the first impact of the crisis was felt in November 2008, the government of President Correa introduced a set of fiscal measures, such as: drawback on custom taxes and reductions of full exoneration from income tax for badly hurt industries. Without losing time, a month later a tax law was passed to increase the overall cost of retaining dollars abroad. It granted reductions on income tax to firms that re-invest their profits instead of transferring them abroad. The law also doubled the tax on currency outflows (covering payment for imports, as well as capital and interest on loans). Finally, the law established a monthly tax on the funds and investments that firms kept overseas. To reinforce these financial measures the Central Bank established a reserve requirement which forced financial entities to hold a share of their funds and investments in the country. A reserve fund offered liquidity to private financial institutions, reinstating some of the functions of the Central Bank as a lender of last resort, a function that it had given up when dollarization was adopted. The recovered role also included the right to apply regulations to protect deposits in the banking system and limits to banking service charges. Additionally, in May 2009, the Central Bank ordered an increase on the interest rates applied to finance the purchase of goods with the intention of reducing the consumption of imports.

The second cluster of measures to face the global crisis was adopted in the realm of trade in order to slow down imports, sustain the trade balance and ultimately stop the drain of reserves. In January 2009, a safeguard was applied introducing quotas and higher tariffs. The safeguard affected 23% of its 2008 imports. The restraints limited 2009 imports to 65-70% of their 2008 levels.

The safeguard was submitted to the WTO to be applied on a most-favoured-nation (MFN) basis. This was a savvy move: being MFN, the measures would have made no room to take into account the Andean regional preferences. Legal for the WTO, but not under the Andean obligations, the issue became a shouting match among neighbors. Ecuador has a long standing deficit with both Peru and Colombia in manufactures. Both countries moreover had hollowed out the Andean Community by negotiating free trade agreements single handedly with the US. So the dispute had a number of political undertones.

The safeguard was justified and authorized under the Article XVIII, Section B of the General Agreement on Tariffs and Trade, on restrictive measures that limit the value or volume of imports to face balance of payment problems. This article had been mostly dormant for a decade, putting the Balance of Payments Committee back to work. After a six month review and negotiation the Committee authorized the safeguards for the tariff lines Ecuador had submitted. These were posited as transitory and short term, with the aim of sticking to the use of dollar while at the same time intervening in such a way as to favor local production and consumption to the extent possible.

The global crisis showed the costs of the dollar straightjacket. The Ecuadorian government could not apply exchange and monetary measures, but it found room in fiscal measures (increasing taxes on currency outflows in order to reduce imports) and trade measures (safeguards), in order to discourage imports and face the balance of payment disequilibria.

Moreover, government policy has given priority to the domestic market and has backpedalled on new North-South Free Trade Agreements (FTAs). Such backpedalling had been opposed by exporters and had clear the rifts inside the Andean Community with the two staunch supporters of FTAs, Colombia and Peru.

Looking under the carpet and combing commitments with a fine tooth comb has shown that policy space cannot be understood in the abstract. Nor is it utopia. It has to be conceptualized within the realm of possibilities where domestic constituencies and political preferences can also pave the way.