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The Effects Of Inflation Economics Essay

A considerable amount of research has been carried-out over the past decade regarding the effects of dollarization on an economy. The literature has included, but not limited the countries of Poland, Zimbabwe, and El Salvador. While only time will tell if dollarization will continue to sustain positive long-term impacts, the short-term has provided considerable evidence of a successful monetary integration.

This research paper analyzed the dollarization of Ecuador in the year 2000. Variables include inflation as well as tourism rates and visitors arriving over time based on a retroactive vacation package price.

A correlational regression determined that neither dollarization nor inflation play a role in the Ecuadorian tourism industry. This determination could have policy implications regarding local legislation, the career choice of tourism among students, and fiscal projection.

Key Words: Tourism, Ecuador, Currency, US Dollar, Economy, Inflation, dollarization, economics.

Introduction

Over the past twelve years, many developing countries have looked to the concept of dollarization to help stabilize their financial systems. Dollarization, the process of officially changing or pegging a country’s currency to the US dollar, began in the year 2000 when Ecuador became the first sovereign state to change its currency to a foreign unit (Lucas, 2009). Soon after Ecuador’s adoption, other countries such as El Salvador, Panama and Liberia adopted the US dollar as the official currency. While dollarization has helped to stop inflation and stabilize economies in the short-run, significant long-term effects can serve to negate out the positive, short-termed effects.

The change to dollarization has impacted many aspects of Ecuador’s economy, specifically the annual $1.214 billion tourism industry (UNWTO, 2011).

The purpose of this paper is to determine the extent and significance that inflation and dollarization have had on the Ecuadorian tourism industry between the years of 2000-2010. This research is guided by the question, has dollarization, with the inclusion of inflation, affected tourism trends over the past decade? Further, it is hypothesized that dollarization is the predominant force and catalyst in sustaining tourism rates in Ecuador, South America.

Additionally, this research seeks to determine if dollarization has concurrently served as a positive economic driver for the Ecuadorian economy, specifically within the tourism industry.

Background

Due to Ecuador’s location with a favorable climate and fertile soil, the economy has long been based on agriculture and other products that come naturally from the earth. In 1967, Texaco became the first major company to discover oil in the highly uninhabited Amazonian region of the country. This discovery led to an oil boom in the 1970s and oil now makes up one-third of all government revenues and forty percent of all export earnings (Kollffel, 2001). Since the economy is vastly based on commoditized products that originate in agriculture, the economy is highly susceptible to natural disasters and global economic problems effecting commodity prices.

According to work published by Penaloza (as cited in Berrios, 2006) and data from the International Monetary Fund (2002), and Census Ecuador (2010), Ecuador’s economy began to falter in the late 1990s due to a combination of several factors including the lack of trust in emerging markets after Southeast Asian economic crisis and sharp drops in global oil prices combined with the emergence of the destructive El Nino weather pattern.

“Exogenous shocks to the Ecuadorian economy in 1998 triggered a severe financial and currency crisis which fully developed during 1999. As a consequence, commodity prices fell substantially below U.S. levels in dollar terms and, apparently, the fall would have continued had it not been for dollarization (p. 9-11).”

Jamil Mahuad, the president of Ecuador during the currency crisis, announced on January 9, 2000 that the country would become the first sovereign nation to adopt the United States Dollar (USD) as its own currency. While Mahuad was ousted from power within two weeks of making this announcement, the new president, Gustavo Noboa, signed a law in March 2000 making the US dollar the official currency of Ecuador. Currently, Ecuador continues to use the US dollar (and some Sucre coins) as its official currency.

As intended, dollarization appears to have reduced inflation and stabilize the economy in Ecuador. While inflation grew at an average annual rate of 41.4% from 1992 -2001 (the third highest rate in all of Latin America and the Caribbean) it has slowed to a rate of 4.5% over the last 10 years. This compares to an average of 6.83% for the rest of the region. The following chart (Figure 1) shows annual inflation rates in Ecuador for every year since 1980 (IMF, 2010).

Figure 1

Data Source: International Monetary Fund, 2010.

When examining the factors that consumers consider when choosing a foreign tourist location, exchange rates matter more than inflation except perhaps in a few extreme examples. Since tourists normally spend a limited amount of time in a foreign country, it is unlikely they will be significantly impacted by inflation unless the host country is experiencing hyper-inflation (Dwyer & Forsyth, 2009) or some other local economic crisis. However, during times of rapid inflation or deflation, the tourism industry has been shown to be one of the first casualties of economic growth.

When tourists seek to reserve hotel rooms or package tour, they are often required to pay in advance. With inflation levels stable, exchange rates do not fluctuate significantly and the price offered at the time of the reservation is similar to the actual expenses during the trip. Due to hyper-inflation, the value of the Sucre fell by 50% between 1998 and 1999 (Beckerman, N.D). If a tourist had paid for a tour a year in advance, then they would have, theoretically, paid half-price for the package and the tour company would have lost 50% of their revenues due to the inflation.

Because the dollar was the global reserve currency and considerably more stable than the Sucre (the Ecuadorian currency), tourist companies using the USD safely took reservations and collected revenues without having to factor in the real or projected inflationary costs.

The currency a country chooses to use often has a large impact on tourism (World Travel Economic Report, 2011). For example, the adoption of the Euro among 17 European nations has made it easier for people to travel to member States since each uses the same currency. Currency can also have a psychological effect on travelers as they decide where to spend their money – they tend to make judgments of price based on perceived value. This means that a tourist from the United States might see a shirt for sale in Mexico for 132 pesos (or $10 based on the exchange rate on April 10, 2012) and decide that it is relatively expensive compared to a similar shirt in the U.S. even though it is actually the same price.

On the other hand, Ecuador has an advantage in this regard since prices are lower than they are in the United States so tourists can compare products as apples-to-apples and will likely view products and services cheaply. For example, $10 for a hotel room in Ecuador will sound much cheaper to an American than 132 pesos. Tourists can also avoid currency conversion fees or bad conversion rates and have a better understanding of how much things truly cost as compared to their reference point-their country of origin. Based on these factors alone, it would initially appear that dollarization would drive more tourists to the country (Emanuel, 2002).

Ecuador is divided into four geographical provinces that attract a diverse group of visitors. The country offers tourism opportunities to the Galapagos Islands, the coast, the highlands and the Amazon Basin. In less than 24 hours, it is possible to travel though all four of these zones via car. Ecuador’s tourism is run by the Ministerio de Turismo, or Tourism Ministry, which uses the national slogan “Ama la vida” (Love life) to attract visitors to the country. Some of the main tourist attractions in Ecuador include Quito (an UNESCO World Heritage Center), the Galapagos Islands (wildlife and center of Charles Darwin’s research), Otavalo (one of the largest outdoor markets in South America) and Volcano Chimborazo which is the furthest point on earth from center.

In 2011, the World Travel and Tourism Commission reported that foreign-born tourism brought in $1.214 billion dollars in revenue which accounts for 1.9% of Ecuador’s GDP. This number is expected to rise at an annual growth rate of 4.2% which would make it a $1.94 billion industry by the year 2022 (Figure 2). This sector currently employs 100,000 people, thus accounting for some 1.7% of total employment in the country, and is expected to rise at a 2.9% annual rate bringing the total number of people employed in tourism to over 136,000 by 2022 (World Travel Economic Report, 2011).

While tourism makes up only a small part of Ecuador’s economy, it presents an enormous opportunity for economic growth and foreign direct investment. Tourism, as a percentage of GDP in Ecuador ranks 147th relative to the 181 countries studied by the World Travel and Tourism Commission.

Figure 2

Extrapolation of data by the authors; World Travel and Tourism Council Economic Report, 2011.

Review of the Literature

Dollarization

Considerable literature has been written regarding dollarization, fixed exchange rate regimen and regional integration along with its primary positive effects on the traditionally defined capitalist market economy.

“The absence of monetary sustainability has caused many emerging and developing economies, such as Ecuador, to rely on the exchange rate as a nominal economic anchor. Consequently, successful (dollarized) fixed exchange rate regimes have been much more common among emerging and developing economies than among high-income countries” (Reinhart & Rogoff, 2002, p. 529).

Although much of the literature analyzes and defines dollarization as a stable and sustainable fiat currency, other research compares dollarization to colonialism (Cheng & Wang, 2011); while Jaconsen (2011) explores dollarization as a stable exchange rate, e.g., Poland’s monetary policy in 1990; dollarization has been shown to increase foreign direct investment, increase exports, balance the trade deficit, and allow for the growth of the gross domestic product (OECD, 2010; Qusipe & Whisler, 2006).

The adaptation of the USD brings many benefits including the mitigation and minimization of inflationary risk in the long and short term, an increase in foreign direct investment (FDI), capital flow inward, a sustainable store of value, and helps to stabilize the exchange rate and increases confidence among consumers and easier financial integration into the global economy (Chang & Velasco, 2000; Guide, A., Hoelscher, Ize, A., Marstone, D., De Nicolo, G., 2004). Minda, as cited in the Economic Review (2006) also points out that dollarization signals a governmental commitment to stabilization. This commitment allows for fixed credit rates and lowers interest rates as the risk of doing business in a dollarized country becomes significantly less.

Theoretically, dollarization is based on Hayek’s 1976 work titled, Choice in Currency. By requiring cheaper and a more versatile currency, governments have the obligation to choose their form of money.

“Dollarization is the concrete manifestation of Hayek’s program of choice in currency, by legalizing currency substitution. This is an indirect acknowledgement of the role of money as private property. Hayek tackles the issue on an individual level; choice in currency has benefits for the entirety of the state; unless the ruling elite sees low levels of inflation, credible monetary policy, and economic stability as negatives” (as cited in Noko, 2011, p. 340).

Bloch (2005) and others argue that dollarization is clearly a way to avoid monetary disruptions and cite evidence showing that while inflation declines significantly after dollarization, gross domestic product rises. They also claim that if a single currency such as the USD were to be used by each country in the Latin American region, a significant increase in GDP would continue to occur while keeping inflation at low rates.

Other research has suggested that financial integration (via dollarization) is more beneficial to an economy on a long-term basis. Frankel & Rose (1998) discovered through empirical evidence that monetary integration is a catalyst for highly correlated business cycles. Looking at 21 industrialized countries, they found a positive correlation between increased trade and business cycle synchronization.

As a sustainable industry, Enriquez (2010) discusses tourism as it relates to economic development and growth in Cuba. She identifies the primary tenets of industry growth including stability and foreign direct investment. Similar to the Ecuadorian paradigm, a key factor in the recovery of tourism in Cuba was the participation of foreign business and foreign direct investment inflow. This participation “impacted the tourism sector directly” (p.96) and accounted for some 400% growth in export earnings. In Ecuador, after the initial currency crisis ended in 2001 and dollarization commenced, foreign direct investment inflows accelerated from a negative 23 million in the year 2000 to over 271 million dollars in 2006 before decreasing to 167 million dollars in 2010 (World Bank Data, 2012).

Sustained Tourism

A successful and sustained tourism industry also stimulates growth in other country sectors such as employment, retail sales, restaurants, taxi fares, artesian crafts, and private housing rents (Colantonio & Potter, 2006) not to mention their associated tax revenues to governmental coffers. Local construction starts can also be considered a positive ripple of tourism. The World Tourism Organization (2012) defines sustainable tourism as, “Tourism that takes full account of its current and future economic, social and environmental impacts, addressing the needs of visitors, the industry, the environment and host communities” (p.1).

Vidal & Fundora infer that as the tourism industry grows the need for new hotels, bars and related infrastructure also grows in proportion (2008). Thus these hidden revenues are an added value benefit and contribute towards a sustainable industry growth rate, a higher standard of living for citizens, higher disposable incomes, more choice for consumers, lower retail prices due to competition, and a continuous upward tick in gross domestic product (Mesa-Lago & Vidal-Alejandro, 2010).

Global tourism today is one of the fastest and largest growing industries. This industry is a fundamental segment of an emerging economy’s economic development and sustainability. A considerable amount of research has been written about tourism, its sustainability and its positive effects on developing economies. Tourism is primary concerned with growth mainly due to its labor intensity as well as bringing local and regional economic benefits (Swarbrooke, 1999). The increase in employment has directly “contributed to the upgrading, modernization, increased efficiency of domestic productive capacity and infrastructure development” (Carty, p.10) as well as developing global connections and related networks (Carty, 2009; Peters, 2002).

Tourism becomes sustainable when combined with a variety of other factors including a stable currency and an exchange rate which makes things less expensive for visitors (Colantonio & Potter, 2006). In the early part of 2000, tourism was the main source of revenue for over 50% of emerging economies (Benavides, 2001). The World Tourism Organization (2012) has identified key trends in the industry. Their research has discovered:

Demand for international tourism grew by 4.6% in 2011;

International tourism receipts for 2011 are estimated at US$ 1,030 billion worldwide, up from US$ 928 billion in 2010 (+3.9%), setting new records in almost all destinations despite current economic challenges in many global markets;

In the first four months of 2012, international tourist arrivals grew at a rate of almost 5%;

The number of international tourist arrivals worldwide is projected to increase by 3.3% a year on average from 2010 to 2030. This represents 43 million more international tourist arrivals every year, reaching a total of 1.8 billion arrivals by 2030 (p.2).

According to the WTO’s Tourism 2020 report, the top three tourist destinations in 2020 will be Europe with some 717 million visitors, East Asia and the Pacific with 397 million followed by the Americas with a projected 282 million tourists (p.1). This projection suggests that tourism will not only survive this negative current global economic climate, but will in fact thrive.

The future of tourism is dependent upon development and economic goals (Shikida, Yoda, Kino, Morishige, 2009)). Given today’s economic realities, the impetus for sustainable industry development must fall on local governments in close collaboration with community members who must be charged with creating and maintaining strategic goals. Integrating tourism to fit within the cultural and environmental structure is an on-going task, mainly due to the continuous growth that the industry has shown both in the past and its projected future growth.

Entrepreneurism is also a factor that should be taken into account when conceptualizing a long-term growth strategy. Accordingly, Koh (2000), suggests that “the greater the level of tourism entrepreneurism, the greater the likelihood that tourism attractions and support enterprises would be created, and consequently, the greater the socioeconomic benefits associated with tourism development” (p.209 as cited in Briedenhann & Wickens, 2004).

In sum, tourism sustainability involves careful planning centered on the opportunity that it allows. Unseen in other industries, e.g. manufacturing, .the continuous growth of tourism, especially in places like Ecuador and other Americas locations, provides stakeholders the opportunity to capitalize on the economic and other benefits that it provides.

Methodology

In order to get a concise understanding of the costs of traveling to Ecuador, the methodology procedure includes analyzing the costs of an 8-11 day, all-inclusive tours to the country at the Economic, 3-star and 4/5-star hospitality levels. The data and subsequent analysis will be calculated by averaging the costs of various tour companies that operate in Ecuador only. These tours will be of the whole country and not of a specific region and will exclude international air fare. This will ensure that the mean price is illustrative of the country and not a particular region.

After determining the average cost of the travel package, the numbers will be valued retroactive to 1991 based on the consumer price index (CPI) in order to compare the prices of these trips before and after dollarization to conclude how the tourist sector has been affected by dollarization. Appendix A shows how the cost of an economic tour may have been priced over the past two decades. The methodology and quantitative analysis uses the mean of an 8-11 day tour to Ecuador based on economic, 3-star and 4/5-star accommodations. The data will be extrapolated to show the average prices of tourism in Ecuador.

As illustrated in Appendix A, the average economic tour costs $1,201 while a 3-Star tour costs $2,205 and a 4/5-Star tour costs $4,435. In order to look at how these prices have changed over time, this study has retroactively predated the value of the costs to 1991 in order to better illustrate how much these trips might have been priced during different time periods of the crisis period of the mid-to-late 1990’s through the early part of 2000.

The key time period and focus of this research is the mid to late 1990s during which Ecuador experienced the crisis of hyperinflation, to the early 2000s when dollarization of Ecuador was firmly implanted. The following graphic shows the regression of an economic trip with the red line representing costs based on inflation in the US while the blue line represents costs based on inflation in Ecuador.

Figure 3

Source: Extrapolation of data by the authors (Appendix A).

Figure 3 indicates that dollarization has stabilized inflation as the two lines merge around the year 2009. It is believed that tourists no longer had to worry about the hyperinflation scare experienced throughout the 1990s, thus felt safe making reservations well ahead of their scheduled travel without fear of consequence.

As it turns out, inflation is not that strong of a determinant in the number of tourist arrivals in Ecuador. A calculation of the correlation coefficient, r, between the inflation rates of 1995-2010 and the number of tourism arrivals was 0.35. This means that only 12.5% of the variance in tourism arrivals can be explained by the variance in inflation rates. While these two variables tend to move together as shown Figure 4 there are more accurate ways to explain the variation in tourism in Ecuador.

Figure 4

Extrapolation of data by the authors, WTO Tourism Data; WTTC 2010.

In the hopes of isolating the effects dollarization had on the tourist sector in Ecuador, this research has also compared the number of tourist arrivals in Ecuador to the number of arrivals throughout the Americas region. These two variables are very closely related with a correlation coefficient of 0.89. The r-squared is also a high 78.7% which shows that these two sets of data are highly correlated. Figure 5 shows this correlation.

Figure 5

Source: extrapolation of the data by the authors; WTO Tourism Data, 2010; WTTC

Discussion

This purpose of this paper is to determine if tourism arrival rates and revenues were affected by external variables such as inflation and dollarization during the period 1999-2004. The analyses of the statistical regression suggest that tourism is independent from inflation – nor did the introduction of dollarization have a significant impact on the number of tourism arrivals. While dollarization provides several conveniences as a world currency and may have helped tourists feel more comfortable booking tours in advance, the main advantage of dollarization was that it has allowed for simple and fast currency conversions which in turn made prices easier to understand.

Based on the analysis of the data, this research suggests that tourists will continue to visit Ecuador regardless of the currency or global economic environment. While the rates of inflation indicate a statistically weak positive relationship with the number of tourist arrivals, comparing Ecuador’s tourism sector to the aggregate total of arrivals throughout the Americas provides a much stronger correlation. The initial hypothesis that dollarization played a significant role in the sustainment of the tourism sector in Ecuador is likely rejected.

Areas of Future Research

Areas for future research can include a similar sampling of tourism in other Latin American countries. This would strengthen the proposition and the findings of this paper stating that tourism rates are not likely affected by the external factors regarding economic condition and the introduction of a new currency; in this case the dollar.

A survey of value and consumer perception would go a long way in predicting trends based on the specific variables such as population percentage living below the poverty line, in extreme poverty, or average wages per month. These results could affect future governmental policy as it relates to tourism, e.g., local legislation and tax allocation.

Additionally, a specific look into dollarization, population standards of living increases, and more specific economic gauges over time could highlight patterns or trends that would serve to open-up new avenues of understanding regarding the tenets of tourism, the role of the local SME business owner eventually adding entrepreneurial investment into this sector.

Quite obviously, to make the claim that economic conditions do not affect the tourism industry without significant, relevant data analysis is somewhat premature, however, as of this writing the trends in tourism appear to be increasing, regardless of the economies in Europe, Asia, or the United States (Figure 5). Tourists continue to arrive in Ecuador in record numbers, and the resulting revenues continue to appreciate over time. A longitudinal study that correlates arrivals, revenues and economic conditions globally using economies that have been “dollarized,” would add to the scope of tourism and those conditions which affect it.

The addition of adding other countries in South America as additional variables would be necessary in order to substantiate the sustainment of the null hypothesis in this particular research; the null was not rejected.

Another area that should be studied and analyzed is the demographic and geographic information regarding the visitors coming to Ecuador. Past demographic trends need to be analyzed to determine the futuristic trends-understanding who is coming, where they are going, and how much they spend in Ecuador will assist local policy makers and community leaders in developing a long-term strategic plan. An underdeveloped, or even worse, an undeveloped strategic plan that clearly shows the capture market share is inefficient, wasteful and counterproductive to emerging economies similar to Ecuador’s.

Finally, it would serve the tourism industry greatly if research would identify, define and categorize some of the basic assumptions regarding the phenomenon of sustainable tourism. Thus the question that perhaps should guide this/these studies is this: Is tourism, per se, an exclusive entity upon itself or is it an activity that encompasses holistic economic development, e.g., infrastructure development, etc.? Knowing the answer to this question would determine if tourism, as an industry is sustainable over time.

Limitations to the Study

Limitations to this study include, but are certainly not limited to having similar data for the twenty years up to the year 2000 in which to better analyze trends through statistical analysis; the lack of an a quantitative n size based original document research or survey instrument, and other data correlations identifying various independent and dependent variables.

Additional limitations include the use of only Ecuador’s tourism as the dependent variable; the probable tourism package sales price is not exact, but estimated; specific costs, including tax and inflation in USD amounts were not calculated or used as a variable, nor was the mean spending per tourist for each geographic location in Ecuador analyzed.

What can be classified as “hidden revenues” were not included in this study because they are not reported or known. These include tourism revenues spent on non-taxed or unlicensed activities including unregulated street vendors, illicit drug purchases especially to tourists from the United States, Ecuadorian businesses that do not comply with the tax laws i.e., failing to report taxable sales, and of course monies spent on corruption including payoffs to governmental or other entities, bribery and graft, i.e., tourists bribing officials for favors, etc.

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