Ecuador | Phase II

Siobhan Morden | January 21, 2022

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.

The markets have not yet been impressed with the first phase of Ecuador’s economic reform agenda. Bond yields still trade in distressed territory above 10%. The markets are still waiting for validation from the International Monetary Fund after a successful first phase. Ecuador has delivered impressive fiscal performance and approved new tax reform. The next phase shifts to labor and judicial reform. There is good reason to remain constructive as the Lasso administration navigates complex politics. The track record so far has been impressive, and there is still momentum for further fiscal consolidation.

Ecuador has been the top performer in emerging markets this year but still has a high beta to external risk.  The country has high yields, benchmark liquidity of $3.7 billion to $8.5 billion in bonds and low ‘Caa3/B-‘ credit ratings.  The low 1% to 6% current yields are also perhaps a technical constraint with total returns dependent on capital gains from positive idiosyncratic risks. There is no quick fix to the high beta status. But confirmation of a strong IMF program could provide some near-term support after the latest review was delayed last December.

IMF support is critical. Stubborn investor skepticism may require formal IMF validation of effective policy management and, more importantly, validation of the important IMF role as lender of last resort.  There has not yet been an official date for the IMF board calendar, though local headlines suggest confirmation next week.  It would be shocking if the IMF took a hard stance over Ecuador’s decision to fix fuel subsidies at levels near market prices while disregarding Ecuador’s success on performance criteria and structural benchmarks. The 2021 fiscal performance was the best in years, and tax reform and high oil prices should reassure further 2.4% of GDP consolidation this year to meet aggressive performance criteria.

Ecuador is probably the IMF’s most successful program in comparison to other countries in the region while also benefiting from the strongest US diplomatic support.  The initial progress on fiscal consolidation is impressive but the broader economic reform agenda still faces potential pushback from the leftist political establishment and an entitlement culture across society.

The next stage of reform should shift towards labor and judicial reform.  It’s an uncertain process with each reform legislation requiring a unique political strategy.  The logical recourse would be to first submit labor reform under urgent economic status to fast track through the legislature.  However, there is no obvious coalition for it with center-left and obstructionist parties dominating. And there is no obvious voter discipline among weak and fractured parties. The automatic approval of the tax reform was a last-minute surprise thanks to breakaway support from a few Correistas during what appeared as a chaotic process.  If the majority of the populist legislature would not approve progressive tax reform, then there are few if any chances of majority support for labor reform.

The initial plan is to seek broad consensus that either encourages legislative support or, more likely, seeks direct public support through a popular referendum.  Labor Minister Donoso suggests a 60- to-90-day consultation period across sectors of society to reach a consensual agreement, similar to the consultations in Costa Rica last year on tax reform. There has been on-and-off reference to a popular referendum, which is a political strategy to bypass a typically ineffective legislative process.  Former President Moreno launched a referendum after less than a year in office and was successful on a popular mandate of political reform. President Lasso also announced potential plans for a referendum next year that would include both labor and judiciary reform and coincide with midterm February 2023 local elections.

This sounds like an astute strategy to capitalize on the roughly 70% rate of underemployment and informal employment and on the anti-establishment sentiment of discredited judiciary institutions. High underemployment and insecurity are the two main voter concerns according to the latest surveys.  The marketing campaign should focus on reform of the Judicial Council and the controversial Citizen Participation and Social Control Council as well efforts to address broader security issues after prison violence last year. The success of the referendum depends upon leveraging voter support of a popular agenda as well as leveraging the support of a popular president.  This will require still economic momentum after the robust recovery last year.