Ecuador | Mind the gap

admin | June 26, 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.

Ecuador’s debt negotiations may seem premature without a formal IMF program and ahead of an important election cycle. The urgent push toward a mid-August deadline comes from cash flow stress and the reliance of a dollarized economy on external credit.  For bondholders, a reasonable framework for debt repayment is better than 12 months of non-payment and potentially worse restructuring terms if debt default triggers a worse economic crisis and worse election results. It’s reasonable to assume that near-term cash flow relief would also reduce the probability that the next administration again restructures the debt.  That said, the successful debt restructuring in itself would not resolve the budgetary stress or the uncertain policy management post elections.  It would just prevent a worse outcome.

The funding gap for this year looks key to understanding how to finance Ecuador’s deficit and avoid roughly 7% of GDP in fiscal adjustment in one year. Too much fiscal austerity could trigger a social and political backlash that would undermine policy management after elections. It also then argues for a high exit yield after restructuring until there is clarity on how to avoid disruptive fiscal austerity. There is so much emphasis on the debt restructuring proposal; however the debt burden is not in itself the problem so cannot offer a solution. The problems include a structural fiscal deficit, low oil prices, low trend growth and the aftermath of managing an extreme budgetary shock through the election cycle.  The IMF loans are insufficient unless they upgrade from normal access to exceptional access.  There are many different fronts to monitor beyond the debt restructuring that are equally important as the determinant for the exit yield.

Exhibit 1: Economic shock has opened up Ecuador’s deficit

Note: *more China loans? Arrears? Creative external sources? Exceptional access IMF program? Source: Amherst Pierpont Securities

The high exit yield after restructuring, say 12%, could potentially be lower if Ecuador can manage the budgetary stress and if lower political stress allows a centrist candidate to emerge that could continue the conservative policy of the Moreno administration.  The number crunching now gets complicated since $1 billion of normal access to the IMF loans will not close the budget gap this year.  The official funding gap is $3 billion to $4 billion on already optimistic assumptions of maxing out multilateral and bilateral loans and $2.7 billion in announced cutbacks to current and capital spending.  It would then be counter-intuitive for the IMF to agree to a program that still faces a shortfall. The IMF relations then would require a serious upgrade from normal access to exceptional access through an election cycle.  After lessons learned from the Argentina 2019 election cycle and the anti-IMF sentiment of the far-left constituents in Ecuador, it’s going to be difficult for the IMF to commit to a medium-term exceptional access program. The political persecution of finance minister Richard Martinez doesn’t show solidarity among the political establishment for orthodox policy management and doesn’t reflect the honest debate about what’s necessary to defend dollarization. The 12-month Stand-by Accord sounds reasonable, but the roughly $1.5 billion of eligible funds through 1H21 would prove insufficient and hence possibly undermine the feasibility of a program.

The “borrowing under an EFF is subject to the normal limit of 145 percent annually of a country’s IMF quota, (IMF quota broadly reflects a country’s position in the global economy), and a cumulative limit over the life of the program of 435 percent of its quota, net of scheduled repayments.” This 145% quota limit was maximized under the recent approval of the RFI but could allow for another $800 million for the remainder of the year as the previous 2019 disbursements roll off in June and December. The cumulative limit of 435% quota would also only disburse $2.1 billion of potential funds and still prove insufficient even if they could be front-loaded for 2020.  This hard constraint under “normal access” would prevent the disbursement of the $3 billion to $4 billion necessary to finance the remaining gap.  The options are either to identify creative sources of external funds, convince the IMF to provide an exceptional access funding program or forcibly close the gap with less spending (run-up in arrears).  The muddling-through scenario will not resolve the IMF relations. The economic team needs to resolve this funding gap or face a worse passive adjustment since a country cannot spend what it cannot borrow under the hard constraint of dollarization. This 2020 funding gap needs a resolution or bondholders will face high exit yields on the implied social and political risks from the extreme fiscal austerity that could backfire on policy management post elections.