Ecuador | Subsidy debate

Siobhan Morden | June 7, 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.

In the wake of the recent International Monetary Fund program, attention shifts back to the specifics of Ecuador’s fiscal adjustment. This is what matters. The VAT hike was an impressive start but is insufficient in itself to stabilize solvency metrics. The next bold move will have to come from lower fuel subsidies. There are a lot of politics to unpack.

The IMF staff report avoided discussion of any fuel subsidy details and projects only small savings in 2024 and 2026. If President Daniel Noboa successfully manages the social and political pressures, then a targeted reduction in fuel subsidies this year would represent additional savings, would reduce the structural fiscal deficit and would show further commitment to fiscal discipline. This story is playing in the local media with only a small window to adopt any austerity measures ahead of the February 2025 elections. If President Noboa reduces fuel subsidies soon, this would represent a positive surprise and catalyst for recovery on bond prices after recent underperformance.

The priority is shifting to a political agenda. President Noboa will be careful to maintain his high roughly 60% approval ratings ahead of February 2025 the elections. The strong re-election mandate is what is necessary to deliver on the IMF program into 2025 and beyond. The campaign cycle hasn’t yet formally kicked off, but President Noboa has all the advantages with high approval and no serious competition. It’s a winning combination. Correismo has been marginalized after their loss through the last two election cycles with no obvious winning candidate. There has been an anti-establishment backlash against all the traditional parties including Correismo. President Noboa will still have to maintain popularity above 50% for a first-round win and dominance within the legislature for either a first minority or simple majority.  The political capital after elections will determine the execution risks for the IMF program.

The window is closing for any austerity measures this year. This is why the IMF backloads the adjustment and credits the tax reform for the bulk of the fiscal adjustment program in 2024.  The 2024 adjustment represents 2.2% of GDP of the multi-year cumulative adjustment of 5.5% of GDP through 2028. The front-loaded adjustment should provide some breathing room on facilitating front-loaded IMF disbursements this year and postponing the execution risks until next year. However, there is still some marginal political flexibility for targeting a small reduction in fuel subsidies. The initial guidance from the Noboa administration was for a further targeting of fuel subsidies this year; however, the opportunity is quickly narrowing as the election cycle approaches.

The revenue side of the adjustment is more impactful for the reliability, immediacy, and transparency.  The lower fuel subsidies would represent a critical component of the fiscal adjustment process. None of the adjustment program will require legislative cooperation. It is instead the management of social pressures. The full liberalization of fuel subsidies in 2019 provoked a destabilizing backlash with disruptive street protests that ultimately forced the reinstatement of subsidies. The similar pushback occurred in 2022 under former President Lasso despite the less aggressive subsidy reductions. The political strategy needs to raise awareness on the need for lower subsidies, target specific subsidy reductions (corporations over individuals and gasoline over diesel and propane), and immunize the most vulnerable sectors of the population against the negative income shock.

There are no specific details on the fuel subsidies within the staff report. The IMF quantifies the high cost with a fuel subsidy bill of 2.7% of GDP in 2023 and also estimates “other” revenues of 0.7% of GDP in 2024 and 0.8% of GDP in 2026. There are no specific IMF recommendations and only marginal targeted savings. The Noboa administration will have to manage the social pressures that de-emphasizes the CONAIE relations after the standstill and unresolved tensions from prior negotiations. The awareness campaign should emphasize that “Fuel subsidies are costly, regressive (disproportionally benefiting the better off), harmful to the environment, and contribute to criminal activities such as smuggling.”

The political strategy is to “focalize” as opposed to eliminate subsidies and target less controversial fuels like Extra/Ecopais gasoline as opposed to diesel or propane. The official projections are for net annual savings of around $500 million if the government unwinds subsidies on Extra/Ecopais and then partially compensates the most vulnerable sectors such as taxi and truck drivers. The conversations should kick off next week among social sectors to raise awareness and support. There is the optionality for some marginal savings of near 0.7% of GDP this year that reaffirms commitment from the Noboa administration, especially ahead of the election cycle. The well-developed plans and frequent official communication suggest latent positive risk for confirmation of a targeted reduction in fuel subsides and upside surprise for bond prices after recent underperformance.