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The 1998-1999 Ecuador financial crisis was a period of economic instability that resulted from a combined banking crisis, currency crisis, and sovereign debt crisis. Severe inflation and devaluation of the Ecuadorean Sucre lead to President Jamil Mahuad announcing on January 9, 2000 that the US dollar would be adopted as the national currency. Poor economic conditions and subsequent protests against the government resulted in the 2000 Ecuadorian coup d’état in which Jamil Mahuad was forced to resign and was replaced by his Vice President, Gustavo Noboa.

Background

Throughout the 20th century, Ecuador was one of the poorer countries in Latin America, and had high rates of poverty and income inequality compared to other countries in the region. By the late 1990s around 45% of the population lived below the national poverty line, making them especially vulnerable. The discovery of oil in the 1960s lead to rapid economic growth, but created an economy that was dependent on exports of oil and agricultural products such as bananas, coffee, and shrimp. Lower oil prices resulted in economic stagnation throughout the 1980s and into the 1990s, as oil exports alone accounted for half of the countries total exports and about a third of all government revenue in the late 1990s. Ecuador’s population and economy can be geographically divided into three general regions: the Pacific coastal region in the west, the central Andean highlands, and the eastern Amazonian regions. 95% of the population lives on the coast or the central highlands, and accounts for the majority of Ecuador’s economic activity. The Amazonian regions are mostly populated by indigenous people who are generally poorer, despite the fact that the Amazon contains Ecuador’s significant oil reserves. Across all three regions, poverty is much worse in rural areas than in urban areas. Ecuador's social and economic inequalities have contributed to internal tensions and political divides on a national level, which became evident during the government's response to the financial crisis.

Causes

Structural Weaknesses in Ecuador

Economic conditions in Ecuador allowed the development of a weak financial system which was more vulnerable to disruptions. The financial sector was also affected by the regional fragmentation between policy makers in the capital, Quito, and banks based in the port city of Guayaquil, the most populous city and economic centre of the country. Financial liberalization policies had been adopted in the early 1990s, allowing easier access to international markets and investors, but they also created a largely deregulated domestic financial sector. Many Ecuadorean banks were well connected to prominent business groups and politicians, and financial supervision and regulation was not strongly enforced. As a result, Ecuadorean banks experienced a credit boom in the 1990s, providing high-risk loans to well-connected customers, assuming that the government and Central Bank would bail them out if needed. Lack of oversight also allowed many banks to engage in lucrative but risky offshore banking in U.S. dollar denominations, creating an informal dollarization of the financial sector, and a vulnerability to fluctuations in the exchange rate.

Shocks and vulnerability

Ecuador's public finances in the 1990s were heavily depended on oil revenue, and public spending was high. In the short term, the financial crisis was triggered by a series of external shocks. A severe El Niño in 1997-1998 caused heavy rains and flooding that caused widespread crop failures and damaged infrastructure costing approximately 13% of its GDP. These shocks occurred soon after several financial crises in Asia (1997), Russia (1998), and Brazil (1998), which were damaging to the world economy. In this context, global financial institutions were more reluctant to offer credit lines to Ecuador and other developing countries. Oil prices plunged in 1998, partly in response to global economic slowdown following the Asian financial crisis, which significantly reduced the government's revenues. These shocks created a situation where the public deficit grew uncontrollably, as the government had to recover from El Niño damage, but had restricted access to oil revenues and international financing. For example, the public sector deficit increased from 2.6% of GDP in 1997 to 6.2% in 1998.

Ecuador was also undergoing a period of political vulnerability in the 1990s. The fragmentation and divided interests of the country resulted in a relatively weak state throughout the 1990s, which never gained widespread support. Populist president Abdalà Bucaram, known as "El Loco", was impeached in 1996, and an interim government under Fabián Alarcón was in power until Jamil Mahuad was elected in 1998, just as the banking crisis was developing.

Crisis and government response

The financial crisis began in the context of increasing public debt and poor economic performance on a national level. In the private financial sector, banks had given out excessively risky loans, and were struggling to maintain liquidity. The banking crisis started in April 1998 with the failure of a small bank, but the ensuing atmosphere of uncertainty caused excessive withdrawals and triggered more bank failures throughout 1998. By August, important bank failures had reached the point where the government could no longer intervene by bailing out and supporting struggling banks. By December, the "AGD law" (Agencia de Garantía de Depósitos) set up deposit insurance, in an attempt to discourage further withdrawals. Another law starting in January 1999 established a 1% tax on any financial transactions, which would discourage withdrawals and raise revenue for the struggling government. However, this tax proved devastating for both the financial system and ordinary people as it discouraged all financial activity and did not prevent deposit withdrawals. Other proposed government policies included increases in general sales taxes and gasoline taxes.

By early 1999, major banks were failing and being taken over and closed by the ADG, while still providing a deposit guarantee. Increasing consumer prices and the depreciation of the Sucre raised fears of hyperinflation, and in March 1999 the government declared a national bank holiday, which ended up lasting a full week from March 8-12. At the end of the holiday, the government announced a widespread deposit freeze in which deposits would be frozen for a full year.This did temporarily slow inflation, but it caused the collapse of trust in the banking system and poor economic conditions. Throughout 1999, the government did gradually unfreeze deposits, but this was followed by widespread withdrawals and more bank failure, due to a lack of confidence in the banks. By September, the government itself had defaulted on external debts as it had spent significant resources supporting the central bank and its deposit guarantees.

Economic effects

Dollarization

Despite the government's efforts to curb inflation, the Sucre depreciated rapidly at the end of 1999, resulting in widespread informal use of U.S. dollars in the financial system. As a last resort to prevent hyperinflation, the government formally adopted the U.S. dollar in January 2000. The stability of the new currency was a necessary first step towards economic recovery, but the exchange rate was fixed at 25,000:1, which resulted in great losses of wealth.

Poverty and living conditions

The severe effects of the financial crisis were especially visible in Ecuador because of the preexisting problems of poverty and national inequality. The general economic uncertainty resulted in loss of jobs and wealth, which was had the most significant effects on people who were already vulnerable. The government was financially limited due to its debt defaults, and had to focus on macroeconomic solutions rather than the social problems that developed during the financial crisis. Measures of poverty, including extreme poverty and the poverty gap, all increased during the crisis and peaked in 1999. Rural areas were especially affected, and metrics such as worse child nutrition, reduced educational spending, and poor health outcomes all showed that the financial crisis had severe effects. An estimated 200,000 Ecuadoreans also left the country between 1998 and 2000, representing 2% of the labor force.

Political effects

President Jamil Mahuad suffered declining popularity ratings throughout the financial crisis, decreasing from 60% in 1998 to 6% in early 2000, and the dollarization policy proved to be particularly unpopular even if it was implemented successfully. Protests led by a coalition of indigenous peoples (CONAIE) and supported by the military occupied congress and forced president Mahuad to resign.