Ecuador | Facing fiscal reality

Siobhan Morden | September 15, 2023

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.

As Ecuador gears up for its coming presidential election, the first pressing issue for the next administration will likely be budget management. Ecuador faces a harsh fiscal reality, but the need for hard change has largely remained on the back burner during the campaign. A stubborn fiscal deficit and scarce financing alternatives look likely to prevent a sustainable recovery in the price of the country’s sovereign debt unless the next administration first recognizes and then tackles the problems.

The divergence in fiscal strategies among the leading presidential candidates has raised eyebrows. While it comes as no surprise that Correismo insists on populist spending and unorthodox drawdowns on foreign exchange (FX) reserves, what is unexpected is that the centrist candidate, Noboa, has also endorsed a similar approach, advocating for central bank deficit monetization. This strategy contradicts the conventional pro-investment growth strategy and may require some quick backtracking.

Noboa’s recent statements were ill-timed, coinciding with a noticeable interruption in the recent gains made on Eurobonds. However, this hiccup should not dampen the cautious optimism surrounding a centrist political transition, potentially affording some interim political capital.

The table seems far from set for the Lasso administration, which has limited time to address the fiscal problem in the few remaining months in office. Finance Minister Arosemena’s goal of a $2.8 billion fiscal deficit for the current year appears unrealistic in light of the latest fiscal data through July. The data reveal a $2.1 billion deficit, with a staggering 12-month rolling deficit of $4.4 billion. Achieving the fiscal target this year seems almost unattainable, especially considering the substantial seasonal spending expected in December.

Several factors contribute to this predicament, including a collapse in oil revenues, reduced foreign currency outflow tax (ISD) and temporary tax revenues, and a lack of restraint on government spending. Spending across all categories has increased, with a resurgence in capital expenditures and persistently expanding payrolls, reflecting the typical fiscal deterioration seen under a weak political mandate and the economy’s sensitivity to oil price fluctuations.

This approach seems far from sustainable for budget management. The Lasso administration has encountered resistance on nearly all fronts in its efforts to reduce the fiscal deficit, including recent investment proposals. Consequently, this year’s financing strategy relies on accumulating arrears and drawing down treasury deposits, partly explaining the decline in FX reserves from earlier peaks this year. The structural deficit of 4% of GDP faces mounting pressures, including the expiration of temporary revenues, a reduction in the ISD from 3.5% to 2%, and setbacks in the Yasuni oil field referendum.

President Lasso has issued stark warnings, emphasizing the lack of budget flexibility to shut down oil fields and forego oil revenues. These challenges paint a bleak picture of Ecuador’s fiscal prospects.

The presidential candidates have not given adequate attention to the fiscal problem. The insistence on drawing down FX reserves, as voiced by Correista candidate Gonzalez and surprisingly echoed by candidate Noboa, is cause for concern. Firstly, such heterodox financing goes against recent central bank legislation and may undermine confidence in the banking system. Secondly, it risks being an ineffective campaign strategy, as a majority of voters consider dollarization sacrosanct. Thirdly, there are no excess dollars to fund the fiscal deficit, with the FX coverage ratio of USD liabilities declining to only 56%.

Additionally, Correismo’s commitment to populist spending, without recognizing the constraints posed by dollarization and the need for fiscal discipline, is cause for concern. While the Noboa campaign emphasizes fiscal discipline as part of its platform, it is framed as a long-term approach for higher investment-led growth. A more coherent approach, including a reversal of the recent central bank deficit monetization, will be required to address the challenges posed by Eurobond and IMF payments beyond 2025.

The cash flow stress will almost certainly require immediate attention from the incoming administration, urging a focus on coherent budget management as a prerequisite for accessing external funding resources. This may logically prompt the next administration to engage with the IMF for a successor program, particularly to negotiate a rollover of IMF loans ahead of the substantial 2025 amortization.

The task ahead is far from simple, given the mismatch of domestic assets and liabilities following the 2020 debt restructuring on Eurobonds. There is an undeniable urgency to define a coherent budget strategy in the aftermath of the political transition, amidst low oil prices, limited financing options, and dwindling treasury deposits. While optimism surrounds the transition to center-right policy management, a sustainable recovery in asset prices hinges on the implementation of a comprehensive economic program and a steadfast commitment to fiscal discipline.