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Ecuador | Making the best of good relations

| May 29, 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 clearly has some friends with a steady stream of commitments and disbursements of multilateral loans over the past few weeks from the World Bank, the International Monetary Fund, the Inter-American Development Bank and others. The IMF has an important role as a lender of last resort, and Ecuador desperately needs loans to cover a fiscal deficit of around 9% of GDP. Ecuador has also delivered beyond expectations with economic reform and effective fiscal management as well as complying with requests for forensic accounting of fiscal revenues and expenses. But Ecuador needs to tap multilateral credit through a formal IMF program.

What more is necessary to re-establish a successor IMF program? It would provide an important boost of confidence ahead of bondholder negotiations as well as critical funds to reduce or close the funding gap this year.  The cash flow stress remains an important risk in the second half of 2020 with forced austerity, the risk for a deeper economic recession and populist backlash ahead of the February 2021 presidential elections. There are no obvious signposts of next steps for a formal IMF program except perhaps the typical coordination ahead of the debt restructuring. There could be some insights ahead of the conference call scheduled for June 1 to discuss the May 29 publication of the staff report on the IMF’s Rapid Financing Instrument. The shortfall on the budget remains an important risk that should contribute to a high exit yield after restructuring, depending on the development of IMF relations.

Ecuador’s latest investor presentation referenced a mid-June timeframe for a successor IMF program.  There was a suspension of the IMF’s Extended Fund Facility last year after the disappointment of the quarterly targets and unintentional discrepancies of the non-financial public sector data.  There has since been much progress.  The IMF announced that these data irregularities have been remedied with the release of revised historic data that also coincide with an orthodox policy shift. Ecuador has delivered on an important structural benchmark with the approval of public finance reform as well as the historic liberalization of energy subsidies.  The rigidity of dollarization has also forced the inconvenience of fiscal austerity with the recent announcement of $2.7 billion in cutbacks this year, particularly focused on public sector wages and goods and services. These cutbacks may be temporary or permanent depending on how budgetary finances evolve.  For bondholders, it has potentially conflicting consequences.  It’s important that the adjustment burden is shared between domestic and external liabilities as necessary to encourage debt relief from bondholders.

However, it’s also unclear whether these cutbacks are politically and socially feasible through 2021. This is a particular concern ahead of the election cycle next year. The election cycle is inopportune as is the populist social and political pressures heighten during the current steep recession, and they may continue into next year.  The bondholders are forced to reassess the debt repayment alternatives with a revised restructuring framework a better alternative than hard default. The IMF would predictably have concerns about commitment to a new funding program through an election cycle, especially with the recent political transition in Argentina a reminder about the risks of policy shift post elections. However, election cycles alone are not the only determinant. The Moreno administration has built up significant goodwill over the past few weeks, and US-Ecuador relations also figure heavily. It’s also critical to reduce the political risks, with multilateral loans a substitute for overly restrictive fiscal austerity.  Too much fiscal austerity could backfire. It’s important that Ecuador source multilateral credit through a formal IMF program.

The IMF has said little about the context for a revised program. There was no immediate release of the staff assessment after disbursement of the RFI, unlike El Salvador or Costa Rica. The latest announcement is the official release of the staff on May 29 with an opportunity to define the potential relations.   It seems unusual not to clarify IMF relations considering all the recent efforts from Ecuador including not only economic reform and fiscal adjustment but also the imminent launch of debt restructuring. This in itself will require close coordination with the IMF, especially as bondholders expect some type of validation on sustainability on the debt restructuring proposal.  Perhaps it’s just a vocal endorsement. The formal request from Argentina to the IMF for a technical document on debt sustainability analysis could be interpreted as a political strategy to indemnify their unwillingness to repay bondholders. We don’t assume the same approach for Ecuador; however IMF endorsement on debt sustainability is a critical pre-requisite for a successor program.

The underfunded program and scarce financing alternatives will likely motivate Ecuador to seek a new formal IMF program.  Perhaps the alternatives downshift to a compromise solution of a 12-month Stand-by Accord as opposed to the previous 3-year EFF. This would serve several objectives: endorsement of the debt restructuring proposal, technical guidance on current policy challenges and commitment of funds to reduce the financing shortfall through this year.  It could also provide the optionality for the next administration to continue with an IMF program for the political and practical convenience of an active program.  This could also assist on reducing the policy risk premium and the subsequent exit yield post restructuring, perhaps closer to 10% from 12%.  The Eurobond debt only comprises 20% of GDP and in itself is not the problem or the solution.  The exit yield post restructuring depends not only on lower Eurobond debt repayment burden but also commitment to medium term fiscal discipline and sufficient funds to ensure stable governability through the election cycle. Therefore, the IMF relations are critical.

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