Ecuador | Positive convexity
admin | September 18, 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.
It is difficult to avoid comparison between Ecuador and Argentina. The main takeaway is that linking a currency to the dollar, as Ecuador does, forces pragmatism. Argentina can print money to cover its deficit, but that eventually backfires with higher dollar demand, balance-of-payments stress and higher convertibility risk. Policy pragmatism has allowed for Ecuador to access external credit with an influx of dollars that should reduce budget stress and allow for a faster economic recovery. That explains Ecuador yields nearly 10% without apparent contagion while Argentina exceeds 13%. And Ecuador still has positive convexity ahead of the election cycle next year.
Low carry remains a constraint for Ecuador’s Eurobonds, but there should be increasing demand if polls continue to reaffirm a dominant frontrunner status for center-right candidate Lasso. The risk looks asymmetric for a positive outcome and potential for yields to break below 9% after elections.
The intensity of credit watch for Ecuador has somewhat subsided after restructuring. It is still important to monitor the economic leading indicators for the political cycle including tax collection, spending and overall budget stress. The early data for September suggest tax collection is starting to recover in sync with the broader re-opening of the economy. It is still going to require efficient budget management through the year including accessing bilateral funds as a pre-requisite for IMF loan disbursement and minimizing the austerity shock. The Moreno administration announced progress this week on renegotiating the China loans with $891 million in cash flow relief from 2020 through 2021 and hopefully a positive signal for still $1.4 billion disbursement of new loans this year. There is a clear cycle of economic stress that could become political stress ahead of the critical election cycle in February 2021. The extraordinary financial support from the IMF should reduce this potential contagion with a $2 billion disbursement at the end September and another $2 billion in December.
The data watch also shifts to poll watch for the first preview of how the official candidates fare on voting intentions. The markets would definitely respond favorably to a concentration of support behind CREO candidate Lasso. There have been several important political developments over the past few weeks including the formal alliance of CREO and PSC as well as the disqualification of former President Correa. There is still high uncertainty because of unreliable polls and a lengthy period until the February 7 elections; however the initial dynamics suggest high likelihood, maybe more than 40%, for a center-right candidate against a fractured and weak radical candidates. It is also notable that the majority of candidates have agreed to preliminary meetings with the IMF, with only Pachakutik the notable outlier. This will require a close monitoring of how candidate Perez performs in the polls with radical views probably marginalizing mainstream support. This all suggests higher conviction for a centrist political transition and increasing optionality for a positive shock for lower yields.
The positive convexity is critical for total Eurobond returns that depend on higher prices and almost zero carry over the next 12 months. There is also potential for a rotation trade out of Argentina and into Ecuador if relative outperformance continues. The near term suggests bias still for positive event risk. The IMF could disburse funds at the end of September with perhaps China soon thereafter, and the first preview of CEDATOS polls could confirm frontrunner status for Lasso. The latent optimism validates a constructive view with optionality for higher prices if political scenarios continue to weigh for policy pragmatism post-elections and an ambitious agenda that would include labor and tax reform.
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