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Ecuador | motivation to adjust

| March 20, 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. This material does not constitute research.

It’s mostly a countercyclical policy shift across Latin America as officials attempt to immunize the downside risks to growth from the coronavirus. Countries with weak governments and weak policy frameworks have challenges. The external shocks in Ecuador are compounded by fixing the currency to the US dollar, consequent loss of currency competitiveness to trading partners and the central bank’s inability to act as a lender of last resort or to ease monetary conditions. The country will likely put a high priority on finding funding and savings to manage budgetary stress. The next litmus test: the willingness to pay the $325 million amortization of the Eurobond’20 on March 24.

The $2.252 billion austerity package announced on March 10 includes a combination of higher taxes and cutbacks in spending.  The majority of the measures are via executive authority with the practical constraints of fewer revenues forcing an adjustment on spending.  The planned $535 million cutbacks in capex spending are less controversial than the cutbacks in $1.1 billion public salaries and current spending.  However, it’s important to tackle structurally high spending, with salaries at $9.2 billion compared to debt service at $3 billion in 2019.   It’ll be a delayed process on tracking the execution of spending cutbacks, waiting to review the monthly fiscal data.

There doesn’t seem to be much popular support for the one-off tax on vehicles ($220 million) that affects not just luxury vehicles but also the middle class. It’s understandable that pro-cyclical austerity measures will face some social resistance on risks of an economic downturn. The legislature was formally was back in session on March 12; however it’s not clear whether the economic reform is a priority on the agenda and whether the deputies will remain in session and productive via telecommute, social distancing and curfews.  The submission of the public budgetary reform (COPLAFYP) would also represent an effort to reboot IMF relations as a structural benchmark for a program that has been in suspension for the last few weeks.

The quickest near term solution should be seeking immediate relief through facilities like the IMF rapid financing instrument for eligibility of 50% or maybe 80% of quota in the first year ($477 million to $763 million). Minister Martinez has also mentioned about World Bank funds of $350 million and other sources of $2 billion (China?).  Neither the conditions nor the progress on drawing down these resources is clear.  There is also renewed focus on attracting investment to the energy sector from the new Oil Minister Ortiz, with a recent offer to investors to build a high conversion refinery.

There has been criticism from the thought leaders in the academic and business community that the recent measures do not tackle the underlining structural weakness of the economy or the intensity of the current crisis. The open letter of suggestions include:

  • 20% salary reduction equivalent to $2 billion in savings across all public employees
  • Reduction in fuel subsidies, maintaining the subsidy for public transport and eliminating the state monopoly on refineries.
  • Collaboration with the financial community to reduce the payment and liquidity stress.
  • Collaboration between employees/employers with flexibility to adjust to the crisis.
  • Creation of a “FX compensation fund” or a temporary surcharge for private sector imports (not used for domestic production) that is destined for compensation of nontraditional exports. This would be administrated via a PPP and funded by multilaterals.
  • Focus on structural reforms after the crisis including labor reform, tax reform (reduction in corporate income tax and tariffs funded with a VAT hike) as well as the budget reform and monetary and financial code reform.

What’s the motivation to adopt unpopular measures when the population is suffering from the negative external shock? There has been competing views from FEFPE, former Correa officials and leftist economists, that recommend default on external debt. It looks to be a difficult few months for the Moreno administration on whether he’s able to deliver fiscal austerity and economic reform against increasingly difficult social pressures. It’s opportune that the next Eurobond payment is next week at only a small amount of $325 million and around $168 million/month in average coupon payments. The pre-emptive default would not offer a solution, especially since the next large amortizations are not until 2022 when external shocks would have long normalized.

The downside risks to economic growth are inconvenient ahead of the 2021 election cycle.  These latent social and political risks should interrupt the recovery in bond prices on any broader recovery in external risk on the fears of a strong leftist candidate. There are still many steps ahead to regain economic stability focusing near term on cashflow constraints and managing social pressures. The Eurobond amortization payment next week should reinforce the willingness to pay with the ability to pay contingent upon effective crisis management and an eventual recovery in oil prices.

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