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Ecuador | Deal risk

| June 12, 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.

The selloff this past week in Ecuador’s debt came as a reminder that any debt negotiation includes deal risk. As the debt ran up from the mid-20s to near our initial average recovery value estimate of 50, the initial euphoria seemed overdone. The past week of profit taking seems reasonable.  Debt restructuring is still in an early phase. Deal risk should decline if there is goodwill to reach a compromise before the mid-August deadline. The stakes are high.

The negotiation tactics

Argentina should serve as a reminder that a compromise solution is near 50 and much better than historic recovery values of 30-40. The stakes are higher for Ecuador with a tighter timeframe to avoid a hard default. There is no room to accommodate the aggressive back-and-forth strategy that has played out in Argentina. A fast track process requires initial friendly repayment terms that should encourage buying into the recent weakness so long as the deal risks remain low.

Ecuador’s minister of the economy and finance, Richard Martinez, emphasized in a televised interview that Ecuador will adopt a different strategy than Argentina.  Presumably he is referring to Argentina’s approach of an initial lowball offer that extended antagonistic negotiations over months with subsequent economic contagion. Ecuador has more to lose in difficult negotiations. It has a dollarized economy that depends much more on capital flows and US dollar supply and demand.

Argentina is again a perfect example of what not to do.  It was a waste of months and scarce foreign exchange reserves only to eventually arrive at a reasonable offer.  It was self-inflicted damage from a serial defaulter that should know through past experience the costs and benefits of difficult negotiations.  The antagonistic negotiation tactics increased mark-to-market risk. Perhaps it is a learning curve for this ideologically compromised economic team on how to reach a negotiated solution.  There are no excuses for Ecuador as the country commences its negotiations with a fast track on mid-August deadline requiring an initial friendly offer to avoid a hard default and a sudden stop or reversal of capital.

The IMF relations

There hasn’t been much definition on the International Monetary Fund role through this debt restructuring or whether there are firm plans for a successor program this year.  The IMF is critical to both influencing the repayment terms as well as the discount rate after restructuring either with or without a formal program.

Don’t assume that Ecuador will follow Argentina’s example of requesting a technical IMF Debt Sustainability Analysis that validates an unwillingness to pay creditors. This would only backfire and unnecessarily complicate negotiations. It’s encouraging that the latest presentations from Ecuador as well as the IMF report on the Rapid Financing Instrument show a high 3% of GDP primary fiscal surplus in 2025.  This may or may not be politically feasible depending on policy management under the next administration, but it does show intent to generate debt repayment capacity that should reduce the burden of debt relief from bondholders.The debt restructuring process has officially launched with bondholder discussions ahead of a formal proposal  at the end of June or in early July. There hasn’t been any guidance on whether IMF discussions run parallel to bondholder discussions, though presumably the discussion have clear influence on the debt proposal discussions since Ecuador has firm intentions for a formal IMF program. This burden sharing debate hopefully forces pragmatism from the IMF to respect the tight deadline as well as respect the willingness of Ecuador to repay with friendly terms.

The domestic political risks

The debt restructuring unfortunately coincides with an acute economic crisis and heightened political risks. The opposition has been uncooperative and instead seeks a distraction by vilifying Minister Martinez with now five impeachment motions submitted to congress.  The latest vote on budget reform suggests that the Moreno administration has sufficient support to thwart the two-thirds vote necessary for impeachment.  However, the market cannot rule out disruptive and unproductive headlines and interference from politicians desperate for populist initiatives and scapegoats through the current economic crisis and ahead of the February 2021 election cycle. The Social Christians have been increasingly uncooperative, launching political attacks against Minister Martinez, voting against economic reform and having PSC President Jaime Nebot publicly reject the IMF.  There has been no honest debate among the obstructionist opposition on what measures are necessary to defend dollarization and effectively manage the economic crisis.  Their recommendations for nonpayment as opposed to restructured payment to bondholders risks backfiring with less capital inflows at a vulnerable moment for the economy. The increasing noise adds more pressure on an already weak Moreno administration and will require more political resolve to push forward through the unnecessary controversy of bondholder discussions. If Minister Martinez is forced to resign under heightened political pressure then Deputy Minister Ferro could quickly resume his activities. However, it would be a logistical setback on debt and crisis management as well as a political setback that may discourage IMF commitment for a formal program. Minister Martinez will likely continue to push forward near term through the political pressure.

These risks will need to be carefully monitored and could create some mark-to-market risks; however the pragmatism of a fast track compromise suggests lower initial deal risk for a country that wants to avoid a hard default and a sudden stop or reversal of capital flows. Argentina may outperform near term as it approaches the final phase and reduces its deal risk towards mid-40s; however Ecuador still benefits from an initial friendly stance and potentially better repayment terms for a higher relative recovery value near 50.

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