Ecuador | Managing budget stress

Siobhan Morden | March 12, 2021

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 may have hoped for a honeymoon in the upcoming transition to a new administration, but it could be a rough one if the International Monetary Fund program gets suspended and large gross financing needs persist.  The next administration will need to focus immediately on budget stress. It is still early to know where policy might go, but the Arauz financing proposals may look like former policies that relied on higher taxes, capital controls and forced domestic investment. The inward-oriented funding strategy would likely reinforce a structural fiscal deficit, weaken dollarization and undermine future capacity to repay debt.

The IMF relations are critical 

IMF relations are critical not only for access to multilateral loans but for what a program represents—commitment to fiscal discipline as the anchor for higher growth and future debt repayment capacity.  Central bank reform is the litmus test. The Moreno administration has already missed the January IMF deadline for approving central bank reform. The consecutive legislative rejections suggest dim prospects for approval. It is not only a weak, lame-duck government but rather the threat of political retaliation from a frontrunner candidate that is adamantly opposed to central bank independence.

The prospect for an IMF program under candidate Arauz is remote 

Adamant opposition to the central bank reform makes it difficult for the IMF to re-negotiate the economic program.  It is not about a slower or less aggressive fiscal adjustment but rather an ideological difference on what is required to strengthen dollarization and growth prospects.  There is no middle ground if there is no commitment to fiscal discipline and only a public consumption growth model with interventionism and controls.

The financing plans will require an overhaul

The sources and uses for funds for 2021 and beyond under an Arauz administration would look much different than the Moreno administration. There would likely be a shift away from multilateral loans and instead an inward-oriented financing strategy.  The IMF path projected an aggressive fiscal adjustment of 5% of GDP through 2025 that would sharply reduce the $8 billion annual external borrowing needs.  The suspension of the IMF program would forfeit not only the $1.5 billion in IMF loans but perhaps also the $3.3 billion in other multilateral funds—and $600 million in bilateral funds—for a total of $5.5 billion or 5.5% of GDP.

There are some positive possibilities and one-off funds on prospects of higher oil prices. Maybe those could tally 1.8% of GDP in extra revenues as well as 1.3% of GDP in the SDR IMF allotment. There is also still the potential for rejuvenating China relations and getting much-delayed bilateral loans of 2.4% of GDP. This would provide some much-needed breathing room during the initial transition through 2021. But those are not in themselves a solution for one-off measures, especially if the Arauz administration were biased toward higher spending. There are few options at an advanced phase of cash flow stress with restricted access to external capital and a saturation of voluntary domestic capital markets.

The heterodox financing alternatives – a high risk strategy

The Arauz campaign pledge of $1,000 for a million families financed with $1 billion in central bank foreign exchange reserves sets a worrisome standard of budgetary management.  There are only $333 million of central government deposits as of March 5, suggesting that spending promises would be financed with private sector bank deposits.  The $5.7 billion in foreign exchange reserves barely cover $4 billion in private sector bank reserve requirements let alone $8 billion in other USD liabilities (NFPS deposits and other reserve requirements). It is interesting that there hasn’t yet been a backlash in public sentiment; however, it’s concerning that private sector bank reserve requirements have declined from the end of January to February 19 from $5 billion to $4 billion with a subsequent decline in foreign exchange reserves. The threat of a 27% ISD tax may encourage capital flight with an estimated $3.2 billion of excess reserve requirement at the central bank and the banking system at a high 83% domestic liquidity ratio (against 60% minimum).

The adamant rejection of central bank independence may reveal intentions to control monetary regulatory authorities that would allow easier access to domestic liquidity including:

• 75% mandatory as opposed to voluntary investment in CETES in lieu of cash for bank reserve requirement ($3 billion in one-off CETES demand)
• Access to other public sector deposits ($2.6 billion end Feb), and
• A higher percentage of forced investment of the minimum liquid reserves in public securities ($7.9 billion excess RML end January).

This would potentially offer a couple years of incremental financing assuming capital controls are effective and depositors retain confidence in the banking system.  These are high-risk alternatives that erode the balance sheet of the private banks, crowd out private sector growth and discourage capital inflows. The fixed stock of domestic USD liquidity would also only provide temporary financing if heterodox policies discourage capital inflows and encourage capital outflows—lessons learned from Argentina. These forced domestic financing strategies are at best temporary and are at worst a threat for de-dollarization.

Maintain a cautious stance with several potential negative event risks ahead including the suspension of the IMF program and Arauz heterodox policy management. The low coupons on Ecuador’s debt will not allow for investors to capitalize on a muddling-through scenario while heterodox policy management would threaten future debt payments.