Ecuador | Every payment counts

Siobhan Morden | February 2, 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.

Every payment counts. For holders of Ecuador debt, there may be no truer statement especially at current distressed prices. The payment stress is now even more acute with historically large arrears and headlines about delayed payments to public workers. Each bond payment should boost investor confidence. But equally important is the austerity agenda including tax reform, fuel subsidies and spending cuts. This agenda should help formalize IMF talks and broaden access to financing while tackling chronic liquidity stress. There has already been an impressive rally in Ecuador debt on optimism about pragmatic policy. If fuel subsidy cuts follow tax reform, look for further gains.

Each bond payment helps show a track record of commitment to debt repayment for the Noboa administration. Eurobond payments are always controversial for a country that faces chronic liquidity stress and a track record of prioritizing domestic over external liabilities.  The cashflow stress is now even more acute with a buildup of more than $4 billion in payment arrears and delay payment to public workers.

That said, it would be difficult for the Noboa administration to default.  Eurobonds were just recently restructured in 2020 and remain a low burden on the budget at 0.4% of GDP against around 10% of GDP for bloated public payrolls. The debt burden was restructured for a much smoother debt repayment profile with upfront liquidity relief of only 0.4% of GDP in Eurobond payments against prior scheduled payments of 2.5% of GDP this year. Eurobond payments are also typically a priority and automatic budget payment. The timing would also be inopportune for a new administration that has adopted an outward-oriented approach for financing and a private sector growth model.

The next critical focus shifts to tax reform as the legislation approaches its final phase for a plenary vote next week. The vote count isn’t looking good, and this may explain the recent weakness on bond prices. The partners on the ruling coalition including the Correistas and the Social Christians are openly against the compromise tax reform proposal. This is going to make it really difficult to reach a 50% simple majority.

However, there are more creative ways to approve these emergency economic bills. The last tax reform was “approved” since there were not enough votes for an outright rejection on the surprise abstention of several Correistas. There is now more political pressure for a compromise solution under the high 80% approval ratings of President Noboa and the urgency to seek financing solutions through the intensity of the security crisis. Passive approval remains the base case scenario for tax reform with 1.0% to 1.5% of GDP in temporary revenues through 2026 and permanent revenues of maybe 0.3% of GDP.

There is the possibility of setback if tax reform is defeated especially since it tends to happen so often for weak institutional cooperation. However, defeat should be a permanent setback. The large political capital and the urgency of the budget stress should force other alternatives. The public discussion about fuel subsidies is growing larger. Finance Minister Vega and President Noboa are quantifying the amount and timing of fuel subsidy cuts while other politicians also openly endorse the proposal.

This public debate is quite welcome and a stark contrast to the backlash against the prior subsidy cuts in 2019 under former President Moreno. President Noboa is adopting a politically more acute strategy with broader political support and targeted progressive subsidies (not the wholesale elimination back in 2019). The initial plans would target gasoline prices (not gas/diesel) of higher income earners and maybe a return of the monthly band system. The social backlash should be much lower, especially considering the active military cooperation on the streets and the defiant posture of President Noboa against CONAIE President Iza.  The potential savings could reach 1% of GDP year and would strengthen any intentions to seek a formal IMF program. The subsidy cuts are unilateral and would probably follow plans for other spending cuts and a delayed shutdown on the Yasuni oil field to maximize maybe 2% of GDP in structural annual budgeted savings.

Any or all of this fiscal adjustment should lower deal risk for an IMF program. The successor IMF program now has to be the base case scenario. All prior controversial measures are less controversial under the urgency of the security crisis and the political clout of the centrist Noboa administration. The IMF program should carry less deal or execution risks under the current reform agenda while also providing rollover funds to lower the gross financing needs.

Eurobond prices have rallied on outlook for pragmatic reform with potential for follow-through gains on any tangible results focused on tax reform, fuel subsidy cuts and an IMF program. It’s still early on execution of the reform agenda while bond prices remain at still distressed levels. The zero coupon ECUA’2030s have only slightly unwound default risk with only a small bounce to 34 from the 12-month average price of 30, which also represents the historic floor on recovery value.

There is still considerable payment optionality on the 20 points of sinking fund payments for the zero ECUA’30s and 6% ECUA’2030s in 2026, especially for the risk/reward analysis of the low price of the zero ECUA’30s. The breakeven return analysis starts to look quite compelling if Ecuador avoids default through the next election cycle in May 2025. The low bond prices still assume a high probability of default in 2025 at the lowest historical recovery value. The improvement on the cashflow analysis under the pragmatism of the Noboa administration should greatly reduce those risks, especially since restructured debt payments do not exceed 2% of GDP a year.