Ecuador | Crisis creates opportunity

Siobhan Morden | January 19, 2024

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 security crisis arrives at a difficult moment for President Daniel Noboa’s administration but may create opportunity for policy pragmatism. The administration’s recent proposal for a VAT hike from 12% to 15% could represent a fiscal game changer and a step towards more aggressive policy management. The VAT proposal still requires legislative approval and only adds 1% of GDP in annual revenues. And although there has been significant political pushback, there has also been support for alternative measures. This may represent the beginning of more pragmatic policy that could include stronger diplomatic relations with the US and a successor IMF program. Eurobonds trading at distressed prices could respond well to these kinds of developments.

The breakout of gang-related violence represents a new challenge for the Noboa administration and resets policy priorities. The initial market reaction was negative after noisy headlines about a more complicated economic environment and the potential fallout from budget stress. But this may underestimate the positive implications of stronger support for tough measures. This is exactly how the Noboa administration responded with a proposal for a VAT hike from 12% to 15%. This is a permanent hike that would go into effect on March 1 and generate additional revenues of 0.8% of GDP this year and  1% of GDP in later years. The government may spend these extra revenues on security—mega jails, military expenses and so on—but this would represent productive spending with long term benefits for foreign direct investment and growth. It would also represent permanent non-oil revenues, and low non-oil revenues has been one of the main criticisms from IMF and rating agencies alike.

The next phase is legislative approval. This will represent an important test of the political capital of President Noboa and of broader support for more controversial measures.  The breakdown of the Assembly is highly fractured with a centrist bias but no dominant ideology and with shifting coalitions more dependent on power sharing. The two prior emergency economic decrees were approved with huge majorities, but none of this legislation was overly controversial.  The PSC and the Correistas were the first to reject the VAT tax hike. This will clearly put the working ADN/PSC/RC coalition to the test with specific focus on the large 37% Correismo block. None of the parties have come out in support. This isn’t surprising for the cultural rejection of tax hikes with the lowest VAT in the region. There was almost immediate back-tracking on what was accidental approval of tax reform during the Lasso administration.

However, there could be room for compromise with Correismo suggesting flexibility for a temporary VAT hike. It’s also interesting that PSC is openly advocating a reduction in fuel subsidies while the RC propose alternative tax hikes. This also does not rule out a VAT hike, remembering that the Correistas provided implicit support to the last tax reform on their abstention. It will be difficult for the political parties to not show their solidarity with a precedence of temporary tax hikes through moments of natural disasters and domestic shocks. The fast-track status allows 30 days for review with automatic approval if not rejected. If the permanent VAT hike is rejected there could still be goodwill for seeking an alternative compromise.

These negotiations should set the stage for whether the Noboa administration broadens political support for an increasingly pragmatic economic agenda. The initial response has been highly pragmatic with a 60-day state of emergency and an executive decree that defines an internal armed conflict and an active (lethal) military response against the terrorist status of 22 crime organizations. There has also been an outreach of US diplomatic support on financial aid and intelligence that anchors other offers of diplomatic support across the region.  That pragmatic stance may also include a successor IMF program. The prospects for an IMF program were already becoming our base case scenario under the pragmatism of budget stress. This security crisis would further strengthen that view on the need for additional financing and resources and the opportunity of higher political capital through effective crisis management.

The security crisis should offer an opportunity for President Noboa to leverage his high political capital—his approval ratings getting a bump towards 80%—for a pragmatic economic reform agenda. The initial response has been favorable but slightly muted with bond prices still unable to break through the upper end of a well-defined trading range. Perhaps this reflects the overhang of prior disappointment of policy reversal on fuel price hikes, tax hikes and more from an uncooperative political establishment. The upside gains still depend on confirmation of broader political support; however, distressed bond prices remain more sensitive to the positive optionality of the latest shift towards policy pragmatism and the opportunity for change.