In 2000, Ecuador dropped its hyperinflating local currency and adopted the US dollar. In 2005, as I noted here, the president of the country was ousted, but there was no currency crisis. Score a point for dollarization. In November 2006 Ecuador elected a new left-wing president, Rafael Correa, who took office last month. In his inaugural address, reports Reuters, Correa threatened to default on government’s external debt:

While Ecuador's state coffers are flush with oil export revenues, Correa has left open the question of whether he will pay what he calls an "immoral burden" of debt obligations left by previous governments.

Bond-rating agencies immediately lowered Ecuador’s credit rating. Prices of Ecuador government bonds have dropped, raising their yields to junk-bond levels. Bloomberg reported last week:

Ecuador's 10 percent bond due in 2030, the country's most- traded bond in international markets, fell 0.10 cent on the dollar to 79.90 at 4:30 p.m. New York time, according to JPMorgan Chase & Co. At that price, the bond yields 12.70 percent. Fitch, Standard & Poor's and Moody's all cut the country's credit rating last month.

And yet, there is no currency crisis. The banking system is also holding up well:

So far the impact on Ecuador's banking industry has been marginal, said Fernando Pozo, general manager of Banco del Pichincha CA, the country's biggest non-state bank, with $2.9 billion in assets. ``Dollarization creates a separation between economic and political issues,'' he said last week in an interview in Quito.

Score another point for dollarization.

There has, however, been a large outflow of foreign deposits from Ecuador’s banks. The outflow, I’m guessing, is because some depositors are worried about bank solvency: the drop in government bond prices may impose losses on banks that hold government bonds in their portfolios. But is that right? Correa's government is only threatening to default on bonds held by foreigners, and not because it can't pay, but in order to score domestic political points. So it seems unlikely to choose to default on bonds held by domestic banks, unless Correa deliberately wants to ruin the banks.

A large enough outflow of foreign deposits could cause liquidity problems for some Ecuadorian banks, just as the same event in Chicago could cause problems for some Chicago banks. But such an event would have nothing to do with the viability of the US dollar as Ecuador’s money, just as the same event in Chicago would have nothing to do with the viability of the US dollar as Chicago’s money. So I’m puzzled by the following statement in the Bloomberg story:

Should Ecuador's economy face a continued decline of cash flow, it may force the government to abandon the dollar as the official currency, said Alessandra Alecci, an analyst at Moody's Investors Services.

"There hasn't been a decline of this size over the past few years,'' Alecci said in a phone interview from New York. ``In a worst-case scenario, if there is a significant withdrawal of liquidity from the system, concerns about dollarization could grow.''

Nothing in the worst-case deposit-outflow scenario “forces” the government to abandon the US dollar; it only forces the liquidation or restructuring of the affected banks. There would be nothing gained – the outflow certainly wouldn’t be reversed -- by the re-institution to a local currency.