Markets Fret Over Ecuadoran Debt

Left-wing economist Rafael Correa’s come-from-behind victory over right-wing businessman Álvaro Noboa capped a roller-coaster campaign that proved to be full of surprises. After surging to the front of the polls in September, Correa unexpectedly lost his lead in the final week before the October 15 first round vote, as Noboa leapfrogged from fourth place to first. Then, in another twist, Noboa lost a seemingly insurmountable lead ahead of the run-off, with a late October 16% point advantage in the polls whittled down to a near technical tie just a few days before the November 26 run-off. In the event, Correa won the election by an impressive 57 to 43% margin, exceeding almost all observers’ expectations.

With a double-digit victory under his belt, Correa appears emboldened, claiming a sweeping mandate. Private investors now are concerned that the president-elect may feel less compelled to stick to the more moderate script that actually helped him overcome Noboa in the second round. This is troubling for holders of Ecuadorean sovereign bonds in particular, since the election has already proven to be a gut-wrenching ride for asset prices. The volatility of course owes to Correa’s consistent advocacy of debt restructuring, including the possibility of a preemptive default as a policy option. Correa’s academic writings and campaign platform are rife with criticism of the past management of Ecuador’s foreign debt, at least some of which Correa suspects is “illegitimate.” Correa has also praised Argentina’s tough stance toward its foreign creditors. Beyond the specifics of his writings, Correa’s message has basically been that the conditionality of multilateral debt is unacceptable; the coupons on Ecuador’s market bonds are too high; and, overall, that debt service would not be prioritized over the robust social spending his administration plans to include in the budget.

Debt restructuring appears unnecessary
On the face of it, all the talk of debt restructuring and default seems somewhat puzzling, since by nearly all measures of fiscal and financial flexibility, Ecuador’s external debt has never looked more manageable. After a half-decade of economic growth and stable debt stocks, Ecuador’s debt-to-GDP (35%) compares favorably to such countries as Uruguay (75%), Brazil (62%) and Colombia (56%). In terms of cash flows, external debt service (interest and principal) should reach only 3.6% of GDP in 2007, while an estimated total public debt service of 8.9% of GDP (including domestic debt) is substantially lower than that of Brazil (22%), Mexico (15.6%) and even the Latin American average (around 10%). Finally, Ecuador faces no significant principal payments on its global bonds until 2012.

Meanwhile, largely thanks to the high price of oil and greater state participation in Ecuador’s energy sector—including the highly controversial takeover of Occidental Petroleum’s (Oxy) operations—the government expects a remarkable fiscal surplus this year of close to 4% of GDP in the non-financial public sector. To date, we estimate there is more than $1.6 billion stashed away in various petroleum windfall funds. Against such a backdrop of manageable financing needs and ample public sector liquidity, an unfriendly debt restructuring would be virtually without precedent.

Notwithstanding international creditors’ understandable concern over the Correa’s comments on debt, there is still reason to believe the president elect could prove more pragmatic than advertised. First and foremost, as mentioned above, Ecuador can afford to pay: oil inflows will allow his administration to install a robust social spending program and still service Ecuador’s moderate debt burden. Second, Correa’s rhetoric on debt restructuring, while concerning, is sufficiently vague that he can still fulfill his promises without resorting to outright default. For example, Correa might be able to lobby multilaterals lenders—Ecuador’s largest creditors—to reschedule some payments. Alternatively, President Chávez—a staunch Correa supporter—has offered Venezuelan financing to help “liberate” Ecuador from the Washington-based international financial institutions (IFI) via early repayment, similar to Argentina’s recent pre-payment to the International Monetary Fund (IMF). Moreover, Venezuelan petrodollars could in theory even provide the funds to facilitate a market-friendly liability management operation to lower the coupons on Ecuador’s global bonds. Venezuela has purchased and then resold to local Venezuelan investors (eager for U.S. dollars) more than $2 billion Argentine bonds in the past year; to replicate this plan with Correa, the Venezuelans would presumably have no interest in seeing an Ecuadorean default.

While JPMorgan contends that a default is unlikely, we concede the possibility exists, especially if: a) perceived cash-flow constraints at the central government level complicate their social spending plans (despite ample surpluses in the non-financial public sector - NFPS); or b) political calculations in the context of a constituent assembly (discussed below) lead Correa to default in an attempt to boost his popularity. But while the bar for default might be lower, we are less concerned that all the talk on the issue might paint Correa into a rhetorical corner whereby some market un-friendly measures can not be avoided. As he ably demonstrated in the second round campaign, Correa can ratchet up or tone down his rhetoric when needed. Despite Correa’s inherently brash and ideological style, one should not underestimate his capacity for pragmatism.

Political confrontation seems likely
On the political front, Correa has prioritized a constitutional assembly to carry out a sweeping reform of Ecuador’s institutions. Indeed, Correa has declared that his ample margin of victory in the second round was a clear mandate for constitutional change that would ultimately look to diminish the power of the congress and the courts vis-à-vis the executive. Beyond his long-term vision for the country, Correa needs the institutional shakeup tactically to avoid spending his whole mandate pinned down by an opposition dominated congress, of which at least 70 seats (of the 100-member body) will be held by parties in hard opposition to the new president.

The timeframe for the constitutional process, which could take most of next year to unfold, would basically be as follows: Correa, on January 15, will call on the Supreme Electoral Court (TSE) to invoke a popular referendum that would ask the public to respond yes or no to the formation of a constituent assembly empowered to rewrite Ecuador’s constitution, and possibly to supplant the current Congress. But Congress contends that Ecuadorean law gives the legislature a say in any constitutional change, and local analysts believe the TSE (which is controlled the by opposition parties) is likely to deny Correa’s request, as happened when President Palacio tried to carry out the same process last year. It will then be up to the Constitutional Court (also controlled by opposition parties) to decide the matter, but this body would probably also be expected to block the new president. In such a scenario, Correa might call on his supporters to help him push the assembly into existence in the face of opposition resistance, with unpredictable results. All told, the deck seems to be stacked for a head-on confrontation between the president and the legislature.

Uncertainty to weigh on macroeconomic outlook
Talk of default and political uncertainty is hardly a backdrop that provides comfort to private investors, but they are not the only concerns. For example, although Correa has repeatedly emphasized that he will maintain dollarization, local observers remain cautious given his past criticism of the regime and a policy agenda that might ultimately prove inconsistent with its sustainability.

On the fiscal side, the incoming government will encounter a large oil surplus, but highly inefficient energy subsidies and robust new social spending plans will coincide with higher public sector salaries and other current expenditure hikes, making medium-term sustainability a concern. And should the new administration follow through with a proposal to lower the value added tax, government income would becoming even more dependent on volatile oil inflows to make ends meet. At the same time, Correa has advocated more government intervention in the banking sector. While the financial system remains solid for now, comments that interest rates and fees are too high and that the banking system parks too much cash abroad could shake confidence. Correa was an enthusiastic supporter of Oxy’s ouster, and has said the 2006 hydrocarbons law, which increased the state’s take in private oil profits, did not go far enough. Finally, regarding trade, Correa has consistently stated his opposition to a free-trade agreement with the US, and has expressed his dissatisfaction with the temporary nature of the extension of the Andean Trade Promotion and Drug Eradication Act (ATPDEA) tariff preferences.

All told, risk of an economic slowdown has increased, as credit expansion could slow and local businesses might consider scaling back their investment plans. The overall concern is that Ecuador would not utilize the current oil boom to improve competitiveness and thereby fortify the fundamentals supporting dollarization. Rather, the policy agenda could actually weaken the regime to the point that it might not be able to withstand a future external shock. Even if Correa’s policies prove more benign toward bondholders in the short term than the market currently fears (as we suspect), longer-term concerns seem likely to linger.
 

Luis Oganes is the Co-head for Latin America Research and Ben Ramsey is an Associate Strategist for Latin America Research at JPMorgan.

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