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Ecuador | Aftermath of subsidy cuts

| October 4, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Market reaction to recent fiscal measures in Ecuador reflects cautious optimism at best about the country’s ability to strengthen its balance sheet, but that underplays the significance of the new effort. The near elimination of fuel subsidies is a bold decision for an oil exporting country with entrenched entitlements since 1974. The IMF has expressed support for the move, signaling a turning point for a potentially successful IMF program that reduces rollover risk and validates an overweight on the longer tenors.

There is an understandable overhang of disbelief for a country that has a track record of serial default and unsuccessful IMF programs, but this cautious interpretation seems overdone. It could take longer for reassurance about execution risk since the Moreno administration faces the threat of an indefinite strike from transportation sector. But there is no margin for backtracking like last year given scarce financing options and limited budgetary flexibility at Ecuador’s mature phase of adjustment.

The comparison to Costa Rica 4Q18 and Brazil in 1Q18

It didn’t take long before Ecuador’s transportation unions launched formal protest against the fuel subsidy cuts with President Moreno responding with a “preventative” state of emergency decree. Is there a risk of backtracking?  The administration is adopting a tough stance on insisting that the measures are irreversible and that they are open to dialogue as opposed to “blackmail” from the strikers. President Moreno benefits from the support of the armed forces and the political establishment. The context now is quite different from when the Moreno administration rolled back the subsidy cuts earlier this year, withdrawing the December 26, 2018, executive decree that allowed for market prices for gasoline (extra, ecopais and super grades).   President Moreno clearly must understand the social and economic implications at the current mature phase of fiscal consolidation and has fine-tuned his strategy on the second attempt.  It was a polished marketing effort on emphasizing the inefficient subsidies that benefit contraband and higher income strata of the population while also offering targeted subsidies for lower income households (bono social).  There is no other option than to resist the social pressure similar to Costa Rica in 4Q18.

These subsidy cuts now represent an anchor to the IMF program.  If President Moreno backtracks, it could jeopardize the IMF program.  Typically when the center or far left finally deliver austerity it’s always a last resort with a clear shift from President Moreno on renewed commitment to fiscal discipline.   The IMF program is critical for its last resort lending that also allows access to external private sector capital.  The subsidy cuts reinforce prospects for successful adjustment after having failed to deliver any noticeable adjustment this year on delays of spending cutbacks and asset monetization program. The re-imposition of the previously retracted measures should show a renewed determination to withstand the social pressures and hence signal stronger commitment to fiscal consolidation.  It seems President Moreno is now more focused on his legacy, similar to former President Temer, than on his political career, with no obvious ambitions for re-election.  It’s becoming an accepted political reality on the need for fiscal discipline, with the opposition hoping to inherit a stable economy through the next election cycle. That is creating broad-based support from the political establishment.

The revamped fiscal adjustment program

It’s important to emphasize the boldness of the recent announcements on eliminating fuel subsidies that have been in place since 1974 and that historically have been the downfall of many LatAm governments. The market should have higher conviction on follow-through for promised cutbacks for goods/services and salaries, especially after the recent progress from June-August 2019. There has been only recent progress on spending cutbacks from bloated payrolls with an over-reliance on capex cutbacks. The IMF has already been flexible in readjusting the composition of the fiscal adjustment after the first review.  These adjustments should continue through the third review.  The recent announcements shouldn’t compromise IMF board approval of the second review; however it will require more active discussion on whether they can reach the target.  It will now be a challenge to reach the PSBR target of $3 billion in 2020 on forfeiting the VAT revenues ($1.5 billion from 12% to 15% VAT hike).

The official estimates are for savings of $1.546 billion in 2020,  total savings of $2.273 billion for the non-financial public sector and $2.123 billion for the government general budget.  The bulk of the savings focuses on the savings from fuel subsidies with additional cutbacks of $484 million of which $334 million are wage bill adjustments.  The economic team has since clarified that the central government deficit should decline to $1 billion in 2020 with a surplus of $2 billion for the non-financial public sector.  These revised targets now look feasible and a significant improvement from the recent deterioration through 2019 that puts fiscal adjustment back on track.  It’s not yet clear ahead of official conference calls today whether there is still commitment to the $3.5 billion PSBR target or whether the economic team now expects less adjustment with a lower tax burden and higher reliance on the asset monetization program.  It would certainly become more challenging to reach the aggressive 5% of GDP in adjustment (2019-2021) without the VAT hikes. This does not temper our optimism that there is now a clear path towards fiscal consolidation. We will still have to closely monitor the monthly fiscal performance on follow-through of spending cutbacks to goods/services and salaries; however the fuel subsidy cuts and tax hikes should greatly reduce the gross financing needs of $5-$7 billion/year.   The Extended Fund Facility does not just prioritize the fiscal consolidation but also emphasizes the medium term progress on structural reforms with the latest measures focusing on competitiveness to strengthen dollarization.

The subsidy cuts represent an accelerated shift from gradualism to shock therapy and reaffirm our view of successful adjustment that reduces the gross financing needs and rollover risk.  President Moreno has been resolute through the social unrest while the IMF should prove supportive focusing on the progress of the fiscal adjustment as well as the competitiveness gains on the medium term reforms including labor flexibility, central bank autonomy, public budgetary transparency, capital markets de-regulation and tax efficiency.  The shorter tenors already validate a successful IMF adjustment program with preference for the cheaper longer 10Y tenors.

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