Ecuador | Governability

Siobhan Morden | May 14, 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.

There has almost been a wait-and-see on bond prices after the initial optimism of the Lasso win. Yields dipped briefly below 9% but then backed up and continued responding more to externals. There is potential for sub-9% yields again if investors start to rotate out of overweight positions in El Salvador to pick up 200 bp in yield. To break below, say, 8.5%, investors would need to see stronger governability and the political support needed for economic reform. The low coupons require a more activist investment strategy. There is positive momentum near-term and potential for full convergence with emerging markets ‘B’ credits if political cooperation points toward a credible medium-term economic framework.

It is a more nuanced investment strategy for Ecuador with only the 0.5% ECUA’30 soon offering relatively attractive 6% current yield after the step-up on coupons in July. The rest of the curve would continue to offer low current yields of 0.8% to 1.5%. Ecuador is no longer the high beta carry trade when 9% average coupons offered a buffer against a track record of high volatility.  This demands a more activist approach with directional gains the main contributor to total returns.

Prospects for Ecuador look constructive short-term. There is positive momentum typical in the early phase of a transition, with headlines of a technocrat economic team and prospects for a revised formal International Monetary Fund program. This should provide some interim cushion from fiscal and external stress and a framework for medium-term debt sustainability.  However, unlike other emerging markets credits with IMF programs, it is not the same anchor for near-term carry returns on deferred coupon payments. Rather, the more important role for the IMF is whether it serves as an effective framework for medium-term debt repayment.

There is still potential for near-term positive credit momentum. Market-friendly reform initiatives from a high-quality technocrat team that has already met with multilaterals to renew formal IMF relations is positive.  The IMF program should relieve budget stress. But USD inflows are also necessary to strengthen weak dollarization with a vote of confidence on commitment to fiscal discipline and investment-led growth.

There are few if any comps with most emerging markets credits with IMF programs trading between 5.5% and 7.0% for benchmark 10-year bonds.  Ecuador remains an outlier as a liquid, benchmark credit with low coupons and uncertain medium-term framework.  The curve should again test below 9% yields with bullish curve steepening similar to, say, the initial phase of curve normalization in El Salvador in December 2020 and January 2021 at 8.5% yields. The favorable technicals may also contribute to this positive momentum as investors reduce their El Salvador overweight and add to what had been just a neutral position ahead of the elections. The rotation out of the ELSALV’29 and into the 0.5% ECUA’30 provides roughly 200 bp Z-spread and takes out 20 points.

The context for further spread tightening to converge with ‘B’ emerging markets credits yielding between 5.5% and 7.0% would require effective governability that reassures commitment to medium-term reform.  It is not just the qualifications of a technocrat economic team but rather the capability of the political team to collaborate with the Assembly on what remains a difficult and controversial reform agenda.  It is difficult to be optimistic after the headline setbacks in Colombia on tax reform and the dominant populist influence within Ecuador.  President-elect Lasso will have to show himself adept on not only raising awareness about what is necessary to defend dollarization but also negotiate a workable coalition in congress.  The headlines and investor interest over the past few days have all focused on what if any potential coalition could emerge from within a fractured legislature ahead of today’s formal transition.

There is no natural coalition across disparate ideologies with the controversial UNES representing the largest single minority at 36% and an unusual power broker on current negotiations to form a voting block with either the 32% ID/Pachakutik coalition or the 21% CREO/PSC coalition.  Recent days have marked the turnover of the Assembly with a lot of politicing on who heads leadership and how to form the 51% voting block required for the Assembly President and two Vice-President posts. The negotiations have suddenly shifted with UNES now an important swing vote towards a coalition with PSC/CREO instead of ID/Pachakutik. Pachakutik is now at risk of losing the leadership as it may potentially shift to PSC. The Assembly leadership is an important partner to the executive, so it would be much more convenient if PSC/CREO assumes that role. UNES may not be a reliable partner on what will probably remain an unstable and fluid coalition dependent upon the specific agenda.  However, the potential for a UNES coalition is probably more opportunistic than dogmatic as they try to reinvent themselves and remain relevant after latest defeat. The recent negotiations would not only strengthen executive/legislative relations but also provide optimism of a potential workable coalition.  The Lasso administration will still have to carefully prioritize the economic agenda with pre-negotiations and socialization process to reach consensus on controversial reforms. Costa Rica perhaps offers the best reference on managing the conflicting objectives of an austerity reform agenda that’s socially and politically viable. If the Lasso-elect administration can successfully maneuver through difficult politics, then this would provide the catalyst for convergence with ‘B’ emerging markets peers.