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Ecuador | flexible IMF

| December 20, 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.

Ecuador remains a top pick among high yield emerging market sovereigns heading into 2020 on the back of new reform momentum and curve normalization. The IMF board recently endorsed Ecuador’s revised reform program, released $500 million in delayed funds and reaffirmed a flexible stance—all reducing the risk of a near-term funding crisis. The debt has rebounded impressively since the October-November defeat of the Moreno administration’s omnibus reform legislation and street protests against fuel subsidy cuts. And the appetite for yield heading into next year should reinforce the performance of ‘B’ credits with positive momentum.

The Moreno administration has shifted political strategy to collaborate with the legislature and with broader political constituencies to reach consensus on the reform agenda. The collaboration may slow reform, but it also improves chances for approval.  The IMF also seems okay with a downgrade from shock therapy to gradualism. The IMF board signed off on a watered down version of tax reform and a yet undefined subsidy scheme.   The tradeoff is that the program is no longer fully funded and concerns linger about new issuance risks for a country that has repeatedly surprised the markets and saturated it with more than $20 billion in cumulative debt issuance.  The Ecua’30 issued last September is still nine points away from par. This should deter any near term issuance; however, it doesn’t resolve concerns about the budget.

There has been no clarity from the Finance Ministry on 2020 sources for the $6.7 billion central government funding program.  The market still needs the final publication of the approved budget. It needs details on the funding gap as well as clarity on potential revenue revisions given smaller tax reform and the risk of less-than-expected savings on fuel subsidies. There is confusion since the IMF targets the nonfinancial public sector. There is no apparent funding gap in 2020 with the original program projecting a $3 billion accumulation in deposits from a PSBR surplus. The questions: Will the state owned enterprise surplus fund the central government deficit through domestic bond issuance? Will the central government need to find alternative sources such as non-market facilities like oil backed loans? The estimated central government funding gap is around $2 billion to $3 billion depending on further fiscal measures such as the fuel subsidy cuts.

The IMF has been flexible with program waivers and revisions that adapt to a slower phase of adjustment. The program remains a multi-year adjustment process that focuses equally on reforms that enhance competitiveness as well as fiscal adjustment.  There are a few non-controversial reforms like the Planning and Public Finance Code (budgetary reform), Monetary and Financial Code (central bank and financial reform) and the Securities Market Law (local capital markets reform) that should not face much resistance when submitted to the National Assembly early next year.  The labor reform is probably the most controversial; however this reform has already been broadly socialized through consultative committees, and, as such, is probably a weaker draft subject to less pushback. There is now a track record of success after approval of the tax reform and a 2020 budget that not only reached a comfortable majority for approval but also drew approval in its original version after the legislature failed to overrule the partial executive vetoes.  This reaffirms not only broad political solidarity and legislative cooperation on controversial reforms but also strong governability through the executive strength of partial vetoes.  This should reaffirm IMF endorsement through 1Q20 and perhaps longer with the legislative agenda on economic reform.

The IMF funds reduce near term rollover and financing risks. However, the fiscal adjustment remains equally important for the still high gross financing needs in 2022 and 2023 and the lower sources of financing for the conclusion of the IMF program in 2021.  This reinforces concerns about debt sustainability and dollarization, especially through the 2021 election cycle. President Moreno will have to show progress on the cutbacks to current spending and progress on the asset monetization program. The election cycle may complicate legislative support and reinforces the importance of pushing through the majority of reforms in 1Q20.  However, President Moreno can continue the adjustment unilaterally through next year with a priority for his legacy and no plans to run for re-election. The recent success is encouraging and shows awareness in the political establishment that there are no alternatives outside the IMF program. This should reinforce more progress on economic reform as well as the reality of cash flow constraints that reinforces more fiscal adjustment and further curve normalization heading into next year.

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