Ecuador: Bumpy Ride Ahead

Ecuador’s decision not to pay part of its sovereign debt is triggering speculation about just how far President Rafael Correa intends to pursue non-orthodox policies. It is even leading to heated debate over whether the country may jettison the US dollar in favour of launching a home-made version. The economy, that was ticking along nicely in the global boom, is slowing fast on the back of the global crisis, weak oil prices, its export mainstay, and these huge uncertainties over economic policies. Worse is likely to come.

The decision by Ecuador to default on part of its international debt commitments can have come as a surprise to few. The second default in a decade had been widely signaled through a decision to set up a commission to decide on the legality of the debt, a tactic that has gained mileage since the Jubilee 2000 debt forgiveness campaign highlighted the issue of debt incurred under dictatorial regimes.

But the pick-and-mix approach that President Correa took to paying down the debt has complicated matters, and highlighted that the country is able to pay but unwilling. Essentially, Ecuador has honoured outstanding debt contracted recently and to its lender of last resort, but declined to pay debt issued as part of restructuring stemming from an earlier default.

The commission recommended last November that Correa default on $3.9 billion of Ecuador’s $10 billion foreign debt, dubbing that portion illegitimate. The non-payment covers global bonds due ‘12 and ‘30, issued as part of a debt restructuring in 2000 and 2005, for which the actual government says the negotiations were secretive, illegal and issued without presidential authorization, adding that dates on the documents were altered and that repayment of the bonds have damaged the economy.

It’s not just international bondholders, whose plight after all is likely to evoke little pity amongst Ecuadoreans, but Ecuador’s friends and neighbours who may wind up getting hurt by the government’s decisions. The Ecuadorean government has toyed with non-payment of debt to regional friends including Brazil and Venezuela, as well as one of the region’s leading investors, Spain.

The decision mixes politics and pragmatism. As a lender of last resort, a reliable source of emergency funds, and an international organisation with whom Ecuador has maintained relations since the 1960s, it made sense for the country to keep up payments to the Corporación Andina de Fomento (CAF). And by agreeing to pay part of its outstanding global debt, those due ‘15, the government can seek to draw a line between illegal and legal debts more clearly. At first, the government delayed payment on its ‘15 series, but honoured the payment within the requisite month’s grace period. The bonds are newer and were issued under the government of former President Alfredo Palacio, when Correa was economic minister.

The other oddity of the decision is that Ecuador’s debt is highly manageable. It is neither onerous in total terms nor is it bunched in the near future. Moody’s points out that the country’s debt-to-GDP ratio stands at around 23%, well below the 85% level during its previous default in 1999 and Argentina’s 150% prior to the 2002 default. Measured against central government revenues, Ecuador’s debt burden is relatively low at 100%, compared to over 500% in 1999.

All that points to a highly politicised decision. “The government’s decision to default is based on ideological and political grounds and is not related to liquidity and solvency issues,” according to Moody’s senior analyst Alessandra Alecci. “The nature of this default, Ecuador’s second in the past decade, is unprecedented as it is occurring in a situation of relative macroeconomic strength, despite the recent downturn in the commodity cycle,” she points out. In December, Ecuador’s government bond rating was downgraded to Ca with a developing outlook, from Caa1.

For many, the non-payment is merely a cunning ruse for Ecuador to slash its debt burden. For Ramiro Crespo, president of Analytica Securities in Quito, the government’s moves are designed to strong arm investors into accepting a haircut. Ecuador’s finance minister has admitted that the country plans to buy back the debt due in ‘12 and ‘30 and is hoping for a hefty discount of at least 70%. Indeed, Ecuador is reported to have hired Lazard as its financial adviser in the plan to buy back global 2012 and 2030 bonds. Lazard was hired by Argentina to help with its debt restructuring in 2002, which suggests that the country is at least savvy in its dealings with bondholders.

Many analysts see calamitous consequences stemming from the decision. International markets will be closed to the government and corporates. The complete lack of confidence in government debt coupled with very low trading levels and recent legislation that allows the government to circumvent the exchange when issuing all point to the withering of the already-moribund exchange. The government’s ability to finance itself will also be hurt: the effects are yet to be seen but the capacity to finance the fiscal deficit has been reduced to zero, Crespo believes.

Fly Away Greenback?
The willingness of President Correa to fly in the face of advice of international organisations, his active enjoyment in riling international investors and his outspoken condemnation of the dollar and the US have helped spread rumours about the country’s willingness to drop the greenback in favour of a local currency.

Dollarization, which was introduced in 2000 after repeated devaluations in the local sucre, has been popular, with polls showing that more than three quarters of Ecuadoreans approve of it. Correa has sent out mixed signals. He has repeatedly said that the country will stick to the US dollar, but also refers to the currency as a “barbarity”.

Economic problems have been heightened thanks to profligacy: the Ecuadorean government projects a budget deficit of 3.3% of GDP this year after a highly favourable few years for Ecuador with high petroleum and remittance receipts. But, unlike Chile, and to an extent Brazil and Colombia, Ecuador did not save for difficult times.

The difficulties of a weak corporate sector and bloated public sector payroll have been further highlighted by the drop in Latin American currencies against the dollar, which has made dollarized Ecuador’s products ever-less competitive regionally. At the same time, both remittances from Europe and the United States as well as oil revenues have fallen, thanks to the global recession.

In a clear sign of economic stress, the Central Bank saw rapid losses in international reserves towards the end of last year, which tumbled close to 20% in the week ended December 19 to $4.8 billion, for example. That led the government and industry to reach an agreement to cut imports by $1.5 billion, a compromise that was reached only after Correa threatened unilaterally to impose spending cuts of over $2 billion.

The measures are necessary as the country notched up a trade deficit of $500 million through November of last year. If oil revenues were stripped out, the country would be running a much more severe trade deficit of $6.9 billion. As it does not print its own currency, Ecuador could run out of dollars unless it curbs spending.
That has Ecuadoreans worried that while Correa may support the greenback now, this is a stop-gap measure and that the dollar will be replaced by the middle of the year. “If the government continues with its expansionary fiscal policy, fighting the international community, adopting laws against markets -- tax reform, financial reform and others ... dollarization has few months to live, according to Mauricio Pozo, former Finance Minister.

Analysts agree the consequences of introducing a new currency in the current uncertain environment would be highly damaging for Ecuador with the likelihood of rapid devaluation, a fate similar to the unlamented sucre that led to the introduction of the dollar in the first place.

Commodities
Ecuador is facing a much tougher environment than before largely thanks to its dependence on oil exports. State-owned and desperately inefficient Petroecuador has increasingly dominated exploration and production of the country’s oil fields thanks to the expulsion of foreigners. It has been reporting ever worse numbers in recent years. The Central Bank of Ecuador, which publishes statistics separating out oil and non-oil elements of the economy, reported a drop of over 20% in petroleum’s contribution to GDP over the last three years.

Estimates showing an increase this year are to be taken with a pinch of salt as the Central Bank has been stripped of its nominal independence, say analysts.

This toxic brew of negative factors is leading to rapid cuts in estimates for GDP growth in the country. Even the central bank lowered predictions, saying that GDP would increase 3.2% in 2009 as against 5.3% last year on its website. These predictions were later removed, presumably thanks to political pressure. Few analysts doubt that GDP will be nearly that strong.

With the global credit crisis increasingly showing its effects on the region, Latin America will see economic growth in 2009 of just over zero, Moody’s vice president Mauro Leos says. He points to Argentina, Venezuela and Ecuador as the three Latin countries most vulnerable to the crisis. Ecuador is an extreme case, given that the nation is currently in default of some of its overseas debts, he adds.

The most vulnerable countries, such as Ecuador, Hungary, Latvia, Pakistan, or Ukraine may experience an outright financial crisis and will require massive external financing to avoid a meltdown, says Nouriel Roubini, professor of economics at New York University’s Stern School of Business and the man widely credited with having predicted parts of the financial melt-down.

For Ecuador, the future is strewn with tough choices. An increasingly isolationist president and rapidly worsening terms of trade could trigger an all-out crisis, dollarization or a sharp drop in GDP growth. None of the scenarios confronting Correa looks at all appetising.

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