Ecuador | Pushing forward

Siobhan Morden | March 22, 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 President Noboa continues to tackle the country’s fiscal deficit, but budget stress dominates the policy agenda. Much of the stress comes from the legacy of bloated payrolls from the Correa era. For now the focus is on the highest wage earners in public sector companies, with only marginal targeted savings. Political constraints dominate. It’s not so much about quickly restoring macro imbalances but more about the practical reality of strengthening governability despite budget stress. The next phase of fiscal adjustment is more difficult. The budget is rigid, and Noboa has to navigatge an election cycle next year.

The recent announcement of wage cuts is a welcome move. It starts to address the bloated payrolls that contribute to a central government fiscal deficit of 3% of GDP. But Noboa has almost no flexibility to reduce spending.  Capex is already at its lowest historic levels at 4.5% of GDP, and it is as the main mechanism for lowering spending in response to the 2014 shock of lower oil prices. There is no flexibility to cut high pensions or debt service while capex and goods and services are at muti-year lows. High central government wages remain the main problem at 9.3% of GDP with wages outpacing nominal GDP over the past two years, representing 40% of the budget, offering higher compensation relative to the private sector and the highest wage burden in the region.

The last International Monetary Fund recommendations focused on potential medium-term (2020-2025) savings of 1.8% of GDP from lower public wages and salaries. The bloated payrolls should remain at the center of the current IMF program negotiations. President Noboa has since kicked off a proactive strategy to reduce the payrolls. This should build goodwill with the IMF and lower deal risk on program negotiations.  The cutback on “sueldos durados” carries the lowest political cost and the fastest execution (50,000 of 500,0000 employees). However, the realignment of the highest paid salaries only targets annual savings of $240 million or 0.2% of GDP. There is no quick fix to maximize savings under the current political and social constraints. The typical strategy to lower the payroll burden is gradual savings from hiring freezes, repressed salary hikes and voluntary employee attrition. Massive layoffs would be hard without private sector employment growth to absorb those losing jobs.

This ultimately could translate into higher execution risks of a successor IMF program. Proactive fiscal adjustment is relevant, especially on the VAT hikes.  The Noboa administration also still benefits from high approval ratings (Perfiles de Opinion for March 2-4) at 74%.  However, this doesn’t yet transform the fiscal accounts with continuing dependence on oil, high and rigid spending, and an approaching election cycle. The political risk comes from populist pressures across the political establishment and social sectors and the broader policy complacency from dollarization. Recent headlines about social tensions in the mining sector reflect difficult governability even under pragmatic leadership.  The optimism of an IMF program should quickly pivot to the execution risks of how to shift the structural fiscal deficit of 3% of GDP into balance through an election cycle and still structural societal populism. The success or failure of a successor IMF program is highly relevant for the higher Eurobond payment burden in 2026.

Eurobond prices have taken a pause after the impressive first stage rally of Noboa pragmatism. The valuations are not as distressed with a bounce off recovery value levels and higher optionality for the sinking-fund payments in 2026 and beyond. I had recommended taking some profits after 50% year-to-date gains with some initial profit taking since last week. The low current yield requires a more tactical investment strategy, especially on tighter valuations that are more sensitive to the policy/political risks through 2026 (and memory of setbacks). This tactical strategy does not suggest a bearish view. The Noboa administration still benefits from high approval ratings and commitment to negotiate an IMF program. The 6% ECUA’30 may also benefit on relative terms with the buffer of its relatively higher current yield at 9% versus the lower coupons of the ECUA’35 and ECUA’40.