Andean roulette

Ecuador’s bankers insist the president’s high stakes political strategy, which has included singling them out as public enemies, is ruining the economy.

Much worse-than-feared production numbers from state-oil firm Petroecuador, stagnating foreign investment in that and other sectors and economic growth that has dropped to a crawl are a bad backdrop for Ecuadorean banks.

As the economy deteriorates, the leftist President Rafael Correa, elected last November, was on a spending spree ahead of elections due on September 30 that he looked set to win. If that were not bad enough for financial institutions, he has been whipping up anger against what he sees as exploitative practices by banks, and advocating new regulations for the sector.

To cool this new environment for investment still further, Ecuador has been playing a game of cat-and-mouse with foreign investors over debt repayment. Banks are recording a sharp downturn in the growth of deposits and in lending, particularly in the key area of microfinance, a mainstay for the small economy.
Mr Correa, a US-trained economist who was previously the country’s finance minister, may be unpopular with banks but he still commands a following with the wider public. At 44, Ecuador’s new president is young, dynamic and won a convincing victory in the polls. He is seen as a breath of fresh air and force for change in a country whose political institutions have been decayed by corruption.

He campaigned clearly on overhauling the mechanisms of state and introducing a new constitution, increasing salaries for poorer workers, enhancing social inclusion and closer relations with other Latin American nations at the expense of the US. Since taking office on January 15, he has gone about fulfiling those promises and has maintained a strong base of popularity.

One London-based investor in Ecuador says that he has warmed steadily to Mr Correa and believes he is making a genuine attempt to root out corruption. ‘‘Correa has very good reasons for his views that Congress and the political elite are corrupt. He has fought the battle with them shrewdly and shown them up,” he says.

The problem is that his economic policies seem doomed to failure. Ecuador is not in a strong position either to fund extensive social programmes or to deter the few foreign investors interested in opportunities by cudgelling those that are already there. Worse still, elections in September were leading to a rash of policy measures that smacked of populism, according to critics.

Constitutional conflict
The elections for a National Assembly were set to be the first big test of Mr Correa’s leadership. Members of the Assembly will design Ecuador’s 20th constitution to replace one passed just nine years ago.

‘‘If drafting new constitutions were a sign of progress and development, Ecuador would be a world leading economy,” quips one banker. He sees the outcome as a lose-lose situation. If Mr Correa and his allies win, they will probably dissolve Congress and the president will probably seek to rule with a small group of advisers and enact institutional overhaul in Ecuador. The unpopular judiciary could share Congress’s fate. But if Mr Correa loses, the National Assembly will be atomised among bickering parties, Mr Correa will presumably resign as he has promised and the task of rewriting the constitution will be gummed up. Paralysis will ensue.

Poor inheritance
The economy had started to wilt long before Mr Correa took office. Gross domestic product (GDP) growth peaked at 8% in 2004, but slowed to 6% in 2005 and 3.9% in 2006. In the first quarter of this year, GDP growth came in at a desultory 0.08%, according to central bank data. It has now revised down its growth forecasts for 2007 from 4.3% to 3.4%, according to María Belén Freire, managing director of research at the central banks.

The main driver of the economy has been public sector and government spending and that was slower than expected in the first quarter, she says. She believes that in the second half there will be a pick-up in government spending, helping to lift the economy.

The central bank’s forecasts are a case of wishful thinking, believes César Robalino, executive president of the Association of Private Banks. He sees growth coming in at more like 2%-2.5% with other bankers seeing 2% as the top of the range.

Mr Correa has been increasing government spending by more than 10% per year while inflation is at 3%-3.5%, says Mr Robalino. Much of the spending is poorly directed. A lot of it is going to large, discretionary salary hikes for public workers and subsidies, for example. Mr Correa has stepped up subsidies on basic goods, particularly fuels. That and the weak dollar have boosted the price differential of petrol between dollarised Ecuador and its neighbours to as much as three times, leading to a surge in smuggling.

In the border zone with Colombia, lines of adolescents sell jerry cans of fuel. That is the tip of the iceberg and as much as 40% may be smuggled out of the country, one banker estimates, meaning that Ecuador is subsidising its neighbours’ consumption. Natural gas subsidies, which are even more generous, have led to a rash of illegal conversions among the taxi drivers of Quito, the capital city. Further subsidy increases include the doubling to $30 of the Bono de Desarrollo Humano, a direct payment to poor families, and a one-off grant to help the poor afford housing comes to $3600 per family. That totals $2bn-$3bn in extra spending per year, which Ecuador can ill afford, says Mr Robalino.

The huge lift in public spending could hardly come at a worse time. Production of petroleum is in freefall. The central bank had a bleak forecast of a fall of 5.8% in production in the first half. Reality was even worse than expectations: production dropped by 7%. Bankers who know Petroecuador say that the company is extremely poorly run and has failed to make needed investments. That the company has an extremely tense relationship with the Ministry of Finance and the Economy (MoFE) does not help.

‘‘Meetings between Petroecuador and the ministry involve lots of mutual recrimination. Petroecuador complains that the ministry withholds funds and the ministry fires back that it cannot endorse Petroecuador’s plans because it does not even include forecasts of investment needs and expected returns,” says an attendee of meetings between the two.

That stalemate is costing Ecuador dear. Private investment has fallen hard: it grew by about 16% in 2006 but growth fell to just 2% in the first half of this year. Although some parts of the economy are faring slightly better, with agriculture growing slightly, at 2.28%, in the first half, it is not nearly enough to offset the bad news.

Mistrust of banks
To say that domestic banks are ill-favoured by Mr Correa is an understatement. He is currently suing a bank for about $5m for impairing his credit history; and a number of his close allies have also lodged suits against banks. The collapse of much of the banking system in 1998-99 and some banks’ excessive and disguised charges since then have made it a deeply unpopular sector with the population at large, as well. That has made the sector an easy target for government intervention. Unfortunately for banks, the Ecuadorean government seems to be taking a number of its cues from Venezuela.
One of the government’s first moves was an attempt to put a lid on interest rates. That was thwarted by Congress, which must approve government laws and is opposition dominated. It put forward a radically different plan that is now coming into effect. This new banking law has been met with a mixture of relief – that it was not Mr Correa’s proposal – and hostility, because it still has interventionist elements.

The Congressional solution outlaws all service charges on loans, which commonly included a 2% or 3% up-front fee. Still, interest rate setting is market based. The central bank is dividing the lending sector into four key areas: consumer, housing, commercial and microfinance. The law provides new formulae that take the mean of all the loan rates charged by banks in the sector in the previous months, calculates a rate that is the mean plus two standard deviations and allows banks to charge up to that level, says Ms Freire.

The central bank is working to further sub-divide the four sectors and adjust for different risk profiles to allow banks more flexibility in charging interest rates because the proposed system is seen as too crude, she notes. The move is designed to curb exorbitant fees by outlawing outliers, and encourages transparency by compelling banks to reveal all charges.

Bankers agree that the moves will enhance transparency but they worry that it will lock out higher-risk borrowers. ‘‘In seven or eight months, we anticipate that rates will have largely converged. That makes long-term lending, where you need the ability to react to changes in the economy fast, much more difficult,” reasons Mario Burbano de Lara, general manager of Mutualista Pichincha, Ecuador’s second largest mortgage provider. That will force the organisation to consider curtailing lending to some customers, he notes. The institution is also finding the slump in the economy is hurting business, representing a double whammy.

Deposits and lending
The political uncertainty, the slowing economy and government intervention have had a predictable effect on deposits and lending. Deposit growth has been falling, according to central bank data. In 2006, deposits were growing at more than 20% and by the second quarter of 2007 growth was at about 8%. The central bank predicts that after elections to the National Assembly deposits will pick up again, but bankers are more sceptical.

The fall in deposits has worsened the outlook for lending. As in most of Latin America, lending had started to become a powerful driver for bank profits in Ecuador. Microfinance lending, typically to companies that employ just two or three workers, grew at more than 100% year-on-year last year, for example. That rate has fallen to about 35% now because of the economy and uncertainties over legislation, says Mr Robalino. It may yet pick up because of the clarity of the new law and as banks adjust interest rates up to compensate for lost fees, he says. Unless, that is, Mr Correa tightens up regulations.

Investment on the stock exchanges of Quito and Guayaquil is stagnant, too. ‘‘Private entrepreneurs don’t trust this government and its economic policy. Mr Correa is not friendly to the market economy, private property and market-led pricing mechanisms,”‘‘ says Mr Robalino.

The moves to control interest rates in the lending sector reflect a wider dislike of debt instruments. Ecuador has publicly see-sawed on its willingness to honour its debt obligations, opening the bonds up to frightening volatility.
The Correa government inherited a large burden of debt from former governments, many of which ran up debt recklessly. Mr Correa’s first finance and economy minister incumbent, Ricardo Patiño, was a fiery and candid social economist and member of the Jubilee 2000 coalition, a group that put debt relief and forgiveness on the agenda of the G-7. He said that parts of Ecuador’s debt were illegitimate and that the country therefore did not have to pay in full.

His statements on the legitimacy of debt and his insistence that Ecuador would use part of a grace period in February to make an interest payment sent Ecuadorean bond prices into a tailspin, notes Ramiro Crespo, general director of Analytica Investments in Quito. Prices swiftly recovered when Ecuador made a surprise payment just before the grace period was to start, he adds.

That change of heart has prompted market speculation that Venezuela, which is reputed to have been a heavy buyer of Ecuador’s credit-linked notes, was involved in persuading the Ecuadorean government to pay up. As a close ally, Ecuador complied. Neither this nor further speculation that Venezuela was manipulating the market for trading gain has ever been proved. However, Mr Patiño was forced out by a strange video-taping scandal: grainy footage of him and other Ecuadoreans meeting bondholders and outlining a plan to force down bond prices was aired on national TV, leading to his downfall. He claimed that it was a sting that he organised to catch the investors who manipulate markets, but the media chose not to believe that story.

Mr Patiño’s replacement, Fausto Ortiz, is more low-key, says Mr Crespo. A former professor of economics at the University of Guayaquil, Ecuador’s largest city, he was seen as an orthodox, relatively liberal economist. He burnished these credentials at the finance ministry, where he was responsible for debt management. The London-based investor is a supporter, and says that Mr Ortiz was pivotal in persuading the government not to default. The debt management role is in better hands with him and he is good friends with Mr Correa, he says.

Mr Ortiz does weigh up his words and is less prone to outbursts, but at a press conference in Quito, he ducked specific questions on Ecuador’s commitments to paying debt. He says that Ecuador’s social programmes must take priority over debt repayment, but insists that the two are not incompatible. He gave vague answers regarding the possible findings of a commission that has been convened to study debt illegitimacy.

Debt reprofiling
Mr Ortiz says that the country will reprofile its debt to smooth out payments. That will be done through shuffling local and international debt payments and with the help of multilaterals, particularly CAF (the Andean Development Corporation) and the Inter-American Development Bank, he claims. Mr Ortiz pulls out two nifty charts, one showing the current payment schedule and the other the schedule after reprofiling is completed. In the first chart, there are big jumps in payment in 2014 and 2030 when $2.016bn and $1.456bn come due respectively. In the new chart, the payment in 2014 is sliced to $996m and in 2030 to a trifling $18m.

Mr Ortiz’s style may be a welcome relief from the abrasive style of Mr Patiño, but it may be no more than just style, say some bankers. They say that the ambitious reprofiling of debt is a nice idea but ignores basic realities. Ecuador’s financial position is precarious. Moody’s rates it a lousy Caa2, downgraded from Caa1 in January. The rapid flight to quality in credit markets worldwide shows just how far global debt investors have moved against lower-rated issuers. That means that even if Mr Ortiz is less opposed to markets and foreign investors than his predecessor, they may be less willing to buy into Ecuadorean plans.

With the deterioration of the economy and higher government spending, investors are no longer asking: does Ecuador want to make its repayments, but will Ecuador be able to meet its obligations, says one banker. Ecuador could face a credit crunch as early as next year. In the meantime, elections and rewriting the constitution are higher up the political agenda than banking and investment. Fiddling, Rome and fire come to mind

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