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Ecuador | capitulation trade

| March 13, 2020

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’s latest austerity package faces a vicious cycle of lower oil prices. For the package to work, external shocks need to resolve or oil prices need to stabilize. The country’s bonds look oversold only if oil prices recover in coming weeks or months and the Moreno administration remains committed to debt repayment.

The country’s initial reaction to the oil shock was to compensate for lost revenues with a combination of potential loans, spending cutbacks and de facto reaffirmation of a willingness to pay debt. It’s fortunate that the country has only one Eurobond maturity on March 24 with the next amortization not until 2022. The latest central bank data shows treasury deposits at $886 million on March 6 and a recent transfer of $284 million of funds from SOEs, which is more than enough to cover this $350 million Eurobond payment.  There are still repo obligations ($500 million) and coupon payments to monitor (around $1.5 billion annualized). The commitment to debt service will depend on how they manage cash flow stress and the duration and intensity of the external shock.

It’s been a capitulation trade. Ecuador, with superior liquidity and inferior credit ratings, has been caught in the backlash of severe contagion. There are too many bonds and too few buyers under the constraint of the split B-/Caa1 credit ratings. The investor sentiment remains weak, and pricing reinforces the (mis)interpretation of a high probability of default. The current prices are now not far from the 30% historical recovery value on nearly 100% probability of default. It seems natural to start thinking about recovery value exercises; however, this is premature. It’s first important to understand the context and timing of a potential default. The willingness to pay is now at its highest on the initial phase of the external shock with ECUA’20 discounting a high probability for payment. The price convergence between Ecuador/Argentina prices contradicts the relative default risks and near term willingness to pay.

It’s encouraging that there was such an immediate response from the Moreno administration on announcing an austerity package; however, the measures were insufficient to immunize against the market stress.  This is probably for two reasons: 1.) lower oil prices require more measures to compensate for lost revenues and 2.) credibility deficit on fiscal adjustment after the backsliding last year.  If Ecuador makes the payment on March 24, that should reaffirm the near term ability and willingness to pay; however, the liquidity stress will worsen if oil prices continue lower or current prices continue for an extended period.

It now becomes a function on follow-through for execution and managing any social fallout.  The execution now becomes critical if external contagion continues over the next few weeks.  It would then require extraordinary resolve to prioritize coupon payments and manage the social stress of the economy vulnerable to a recession. There is only $1.5 billion in annual coupons with these payments dependent upon commitment to an austerity program and identifying other sources of liquidity.

The latest press release discusses $2 billion in new financing late this month/early next month and ongoing debt liability management negotiations with bilateral creditors (China).  It’s not clear the source of funds – perhaps new repo lines of credit?  The press releases also states continuous coordination with the IMF and now recent focus on the rapid financing instrument (RFI). The potential RFI funds of $500 million are not an obvious substitute to the $2.8 billion remaining on the IMF disbursements through December 2021 with the other $2.7 billion multilateral funds also probably in suspension.  The recent IMF statements seem collaborative; however the recent measures have not yet prompted an official resumption of the EFF. Finance Minister Martinez suggested a new calendar for disbursement as early as next week.

The National Assembly is now back in session. There are a few bills that will represent a litmus test for solidarity and awareness about the severity of the external shocks. The obstructionist opposition like Revolución Ciudadana has been vocal about their opposition as well as labor union FUT and indigenous organization CONAIE; however it’s critical that center right parties like CREO realign with the governing coalition.  There was widespread support for President Moreno in the aftermath of the Quito protests in October.  It’s now important that the political establishment is responsive to the budgetary stress and supportive on the economic reform legislation like the budgetary structural reform law of best practices and transparency as well as the newly proposed one-off tax on luxury vehicles ($220 million of the $2.25 billion austerity package). These specific measures may not represent important cashflow relief; however it would represent an important show of solidarity for a country that needs broader social acceptance of the austerity measures. The risk is whether the debate shifts from pro-cyclical to counter-cyclical policies.  There has been renewed dialogue between the economic team and the legislative coalition to build support with submission expected on March 16.  It’s now a scraping by process to reduce budgetary stress and retain support against pro-cyclical policies. The current bond prices may still maintain a high correlation to oil prices; however the near 100% probability of default remains out of synch with strong intentions near term to remain solvent ahead of the ECUA’20 payment on March 24.

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