The Big Idea
Ecuador | Policy momentum
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The second mandate for Ecuador’s President Daniel Noboa has officially kicked off with no shortage of problems to fix ranging from security to oil prices to ambitious IMF fiscal targets. There have been unilateral executive announcements on subsidy cuts, two urgent economic decrees sent to the legislature and the kickoff of a constitutional referendum on allowing foreign military bases. It is a busy policy agenda. This isn’t surprising for a new presidential mandate and the rationale for why Ecuador looks like good relative value. It is the logical opportunity to capture initial policy momentum as the still excessive risk premium of stressed bond valuations unwinds.
None of the administration’s measures alone are particularly relevant but in total now appear substantial. This could represent the beginning of a transition to improve security, reduce the fiscal deficit, broaden investment in strategic sectors and strengthen political capital. This should at least argue for bond valuations to retest 2021-2022 price levels and converge with other emerging markets distressed credits.
The measure most relevant to bondholders is the prospect for tax reform, incremental multilateral financial support and the prospects for stronger political capital with durable legislative coalition. The possibility of success on all these fronts would allow for valuations to maybe even cross over from distressed to normalized levels if Ecuador makes amortization payments in 2026 and beyond. This is the main driver on valuations: the possibility of avoiding default through the sinking fund amortization payments of the Noboa administration.
Let’s break down the announcements. The cumulative subsidy cuts at 0.5% of GDP make a dent on the roughly 1%-of-GDP in IMF fiscal adjustment recommendations. The fiscal measures purposefully targeted the corporate sector to avoid the social backlash of targeting individuals. This may not be ideal from a growth perspective, but it reflects the political and economic reality after having to backtrack on prior austerity measures (2019 fuel subsidy protests). The next set of austerity measures (maybe another 0.5% of GDP) should focus on cutting back budgeted spending by targeting the high 10%-of-GDP public payrolls. This will require close monitoring of the monthly fiscal data as opposed to any specific headline announcements.
The real litmus test is tax reform. The Noboa administration already submitted a draft proposal last year as part of the structural benchmark of the IMF program. Finance Minister Sariha Moya publicly referenced tax reform in an interview this week. This signals commitment to the IMF program and to the critical revenues necessary to improve budget stress ahead of higher Eurobond payments next year (and necessary counter measure to reduce oil dependence). However, the controversy of tax reform carries high execution risks. This will depend upon the political capital of the Noboa administration. Noboa needs to build popular support with success of the security measures and leverage a stronger majority legislative coalition.
There is room for optimism on building political capital. There may be less market focus on the urgent economic decrees as they focus more on security measures than actual economic reform. However, successfully building workable majority coalitions could provide a boost to governability that will be necessary to leverage support for more controversial measures. The security measures under the urgent economic reform legislation may provide a boost in popular support for President Noboa as well as show the ability to control a majority coalition. The final approval is expected shortly. There has also been progress on the public contract urgent economic legislation that was submitted this week. This would tackle corruption and maybe provide some budget flexibility or incentives for higher foreign direct investment. This is quite relevant near-term if Ecuador is able to negotiate upfront royalty concessions and medium-term attract investment to the mining and oil sectors.
The legislative agenda may pivot or run parallel to a consultative referendum. The legislature just approved 82-to-69 a constitutional reform that allows foreign military bases. The next steps are a constitutional referendum for final approval 45 days after approval from constitutional court. This is quite relevant. The prior view was that referendums through direct popular vote represent a higher risk strategy for economic reform that could distract from a more productive legislative agnda and risk a defeat similar to the last referendum in April 2024). This is maybe too pessimistic. The re-opening of US military bases could also offer a serious improvement on security issues and a secondary positive impact on growth and governability. The popularity of foreign military bases may also provide a popular platform and may not serve as a distraction if the Noboa administration can include economic reform within the referendum or pursue economic reform parallel in the legislature. The Noboa administration would be launching a referendum earlier in his mandate at higher approval ratings and also maybe learning from prior setbacks on how best to re-present the economic reforms. The stronger governability is critical on tackling the controversial tax reform or other reforms (labor and investment reforms).
The bottom line is higher conviction that prices may retest the 2021-2022 multi-cycle price highs from stronger policy momentum. This also recognizes the possibility that there could be a second phase of outperformance that should depend on IMF support, political capital and ultimately the ability to make progress on substantial economic reform (tax reform) that should increase the probability of debt repayment into 2026 and beyond. This could maybe extend bond prices to the peak 2021-2022 price highs (72 on 2035s) or maybe discourage profit taking after impressive 20% year-to-date emerging markets index returns. This should also depend on external risks with a higher beta sensitivity to maintain realignment to other high yielding emerging markets credits.
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