Ecuador | Still underappreciated

Siobhan Morden | December 10, 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. This material does not constitute research.

Ecuador’s bonds have finally bounced off distressed levels. A headline from President Guillermo Lasso reaffirming that tax reform would avoid constitutional challenges and a suspension of the comptroller’s Pandora Papers investigation proved the catalysts. But the market still does not seem to appreciate the successful management of the Lasso administration, which may prove transformational for the economy. The country has shifted toward higher trend growth, likely beginning next year with progress on 3% of GDP fiscal consolidation. Investors should hold a high conviction overweight and target the yields closer to 8% than 10%.

There is typically a lift to investor sentiment after approval of controversial reform, especially for a country with a credibility deficit and a track record of heterodox policy management.  The logic suggests that the positive shock to consumer and business sentiment would mitigate the downside risks to growth from the demand shock of fiscal austerity.  Eurobonds haven’t yet shown the euphoria that should be expected after approval of potentially transformational tax reform and successful policy management under the Lasso administration.  Perhaps this reflects the thin year end liquidity or concerns of policy reversal from the latent social and political pressures.

There was also some relief this past week on that front.  First, the Pandora Papers investigation was dropped on insufficient evidence. Second, the Pachakutik party that initially submitted a repeal of tax reform later announced goodwill for collaboration.  President Lasso also announced that the tax reform would not be vulnerable to legal challenges. Perhaps markets are waiting to make sure there isn’t any fallout or pushback for policy reversal.  The rule of thumb is that a strong leader with high approval ratings should have significant political clout.  There have been several incidents over the past few weeks that should reassure. PSC and ID deputies blocked the impeachment threat from UNES. And then surprisingly, UNES indirectly assisted President Lasso on the approval of tax reform.  After having survived so many policy mistakes under former President Moreno, there should be appreciation and recognition of the political adeptness of President Lasso.

Next on the agenda is labor reform.  The fast-track legislative process probably isn’t the right plan after the tax reform experience. That explains the recent decision to push the reform into next year.  This is logical. The Lasso administration needs to adopt a different political strategy for the unreliable coalition. There is flexibility with no urgency to approve this reform under the IMF program.  The near-term strategy is to build consensus across society for either bullying the legislature to respond to public opinion or bypassing legislative authority and seeking direct support through a referendum.  The bottom line is that high near 70% informal employment demand labor market flexibility. The direct appeal to the majority under-employed and bypassing the special interests in the legislature reaffirms a referendum approach. There is room for optimism for progress next year.  The challenge for the Lasso administration is to maintain their high 60% popularity with hopefully the benefit of the cyclical economic recovery.

The investment reform is not as straightforward.  There were already some slick oil reforms embedded into the umbrella tax reform including migration from service contracts to production-sharing contracts, private sector concessions for exploration or exploitation of oil fields and the delegation of public fields to the private sector. There is probably still some necessary revisions to the hydrocarbon law and it’s not clear what other specific reforms will require legislative or referendum approval.

Our main takeaway is that 10% yields do not reflect the positive credit momentum. The tax reform alone should have been a positive shock to immunize against external risk factors and push yields back to recent lows. There is no other country approving tax reform and no other country that will be able to deliver an impressive 3% of GDP fiscal consolidation from 2021 to 2022. This would exceed 2019 pre-pandemic levels to tackle the worse debt ratios.  Ecuador is also unique for its strong IMF relations through next year, thanks to having approved the one structural benchmark this year that will reassure on fiscal performance criteria next year. Ecuador remains our top pick on the low liquidity risks (restructured debt and multilateral support) and the improving solvency risks (economic reform momentum). Our preference has been the 5% ECUA’30 that should benefit not only from the bullish curve steepening but also from higher current yield over a lengthy multi-phase economic reform process.