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Ecuador | Watch the gap

| July 24, 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 saw some welcome relief from its debt in the second quarter, allowing for stimulus spending in May. But financing sources are soon running dry. The government stands $300 million in arrears to public workers and has made $500 million in payment-in-kind to suppliers and local governments with scarce alternatives in a dollarized economy. The debt restructuring more importantly could represent an important pre-requisite for sourcing other external credit from China and maybe the IMF. The markets seem complacent about the IMF condition as well as deal risk on the restructuring and budgetary stress from a financing shortfall. This is what should determine whether the exit yield is 10% or 12%.

The IMF role is important.  The debt restructuring could be in a pseudo limbo if there is no formal IMF program.  The protracted standstill could also complicate the resolution of the debt crisis if an 80% minimum threshold does not “cure” the default, as several debt series are excluded for not having reached the 50% minimum threshold. It would then require a subsequent follow-up offer under an aggregated single limb vote, allowing one vote on all relevant debt. Buchheit and Gulati best explain in their recent briefing about the collective action clause controversy: “Ecuador has proposed that if in the first round restructuring holders of more than 75% of the outstanding principal of all bonds included in that original offer accept the deal, the issuer will be free to launch a second, “Uniformly Applicable”, offer to close out minority holdouts from round one.”

The settlement date is either August 7 or August 20 or September 1. It is not clear that the IMF will respect those deadlines.  The IMF condition was included on the request of the bondholders, and although the IMF spokesperson suggests engagement for a successor program, there are lending constraints with “normal access” insufficient to close the $3 billion to $4 billion funding shortfall and the uncertain political cycle potentially compromising the “exceptional access” criteria. Perhaps bondholders would provide consent for a protracted standstill until there is an IMF program with interest accrual on the PDI bond offering an interim solution. However, this does not resolve the funding gap and the outlook for policy management after elections.  The IMF program is important not only for its technical advice and the framework for policy management after elections but also as a lender of last resort to prevent a severe economic shock.

Ecuador’s future debt repayment capacity depends on policy continuity to reduce the tail risks of far-left managers that either threaten dollarization or pre-emptively force another debt restructuring.  The budget shortfall needs to be resolved or otherwise the economy could suffer an extreme shock that could backfire, tilting Ecuador towards populism and Correismo.  The recent headlines of deferred payments and arrears are not encouraging.  The latest official data shows a splurge of spending in May thanks to the benefit of multilateral loans. The second half of the year will be much different with pressure to cutback spending and more effort required to source external credit.  The budget execution risk is now much higher.

The funding program still needs to clinch the $2.4 billion in China loans and then source another $3 billion to $4 billion in external funds outside of multilateral sources, assuming the IMF does not offer “exceptional access” loans.  This looks challenging. There are few if any obvious alternatives. Ecuador has exhausted the emergency multilateral loans for what remains a large $14 billion financing program and a programmed fiscal deficit of $7.7 billion. The deficit is based on an optimistic expectation of $2.7 billion of spending cutbacks in the second half of 2020 and only $1.9 billion of tax loss.

Bondholder relief is not in itself the solution.  There is still fluid credit risk. Debt repayment optimistically requires a trend 3.1% of GDP primary surplus and 2.5% GDP growth. The budget stress is an important determinant of the political risks that will then determine policy management after elections. The market should remain cautious until there is clarity on IMF relations and the funding for the 2020 budget gap.  The current bond prices at a 11% discount rate appear overly complacent to not only the residual deal risk for the debt restructuring but more importantly the post-restructuring budget stress management.

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