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El Salvador’s experience in dollarization

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On the way back home from Honduras, my plane landed briefly in El Salvador at San Salvador’s airport.el salvador

Not wanting to pass up a brief opportunity to try my first Salvadoran pupusa in El Salvador*, I started looking for a cash machine to withdraw some local currency.  Within seconds, however, I remembered that El Salvador switched from the colón to the US dollar 12 years ago, so of course there was no need, and I began thinking a little more about why El Salvador adopted the US dollar and whether it has seen any benefits from doing so in the past decade or so.

That decision was among the most important of the administration of Francisco Flores, El Salvador’s president between 1999 and 2004, and a member of the conservative Alianza Republicana Nacionalista (ARENA, National Republican Alliance).  Flores became one of the top US allies in the region at a time when Hugo Chávez was cementing his control on power in Venezuela.  Not only did he stand firmly with US president George W. Bush over regional affairs, he even deployed Salvadoran troops to Iraq in support of the US invasion.

Dollarization was controversial even at the time, but the policy goal was that it would reduce El Salvador’s interest rates and facilitate trade — this was in the era before the Central American Free Trade Agreement (CAFTA), which came into effect in 2009 among the United States, the Dominican Republic and four Central American countries.**

But the broader economic benefits haven’t materialized as fully as Flores might have hoped a decade ago — El Salvador’s GDP growth rates have lagged behind even some of its poorer Central American peers in the past 12 years:

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The entire Central American economy is tied heavily to the US economy due to massive trade and remittances from family members living and working in the United State.  That’s especially true for El Salvador, because many Salvadorans migrated during the brutal civil war during the 1980s (in the Washington, DC metro region, for example, Salvadorans represent the largest Latino nationality group, outpacing even Mexicans).  With around 6.3 million people, El Salvador has over three-fourths of the population of Honduras, but less than one-fifth of the area of Honduras.***

But it’s been essentially the sick man of Central America for some time, routinely underperforming Honduras, which is struggling under the weight of political polarization, trafficking-related violence and massive corruption.  El Salvador faces those problems as well, but it’s generally believed that those problems are at least slightly less drastic in El Salvador.

What’s clear is that while dollarization may (or may not) have worked for Panamá and Ecuador, the benefits have either been too small for El Salvador to realize or, worse — and more likely, dollarization has actively hampered the Salvadoran economy.

Salvadoran central bank president Carlos Acevedo earlier this year admitted that dollarization was ‘a sack of unfulfilled promises’:

Bank President Acevedo made his most recent statements (reported by Active Transparency) following the release of a government study on dollarization, which reached some rather negative conclusions. The report found that many key economic indicators, including exports and GDP fell, while inflation and interest rates rose. Dollarization has failed to shield the economy from downturns and instead made El Salvador more susceptible to instabilities in the U.S. economy, as witnessed during the 2009 recession. The Economista published an article yesterday reaching very much the same conclusions.

In his statements this month, Acevedo said dollarization was “badly designed, improvised and lacking consultation,” and that El Salvador’s fiscal performance with dollarization was the worst in sixty years. He also said the performance was so poor that even proponents of dollarization could not ignore its negative impacts.

Prices in San Salvador’s airport do seem to be higher than prices in Tegucigalpa’s airport, though perhaps the better comparison is to the swankier airport in San Pedro Sula.  But there’s definitely a sense among Salvadorans that consumer prices rose after 2001, though the reasons for that phenomenon remain an open question, even among economists.

Another IMF report from 2011, however, indicated that dollarization had reduced interest rates between 4% and 5%, thereby contributing to savings and boosting GDP by 0.25% to 0.5% annually.

It’s tempting to argue that El Salvador is suffering from the same fate as the eurozone — i.e., that El Salvador and the United States do not comprise an optimal currency zone), Salvadorans are ‘stuck’ with US monetary policy, which may not be appropriate for the Salvadoran economy, and there’s obviously no mechanism for fiscal transfers from the US federal government to the Salvadoran government.   Continue reading El Salvador’s experience in dollarization