By Lucien Chauvin
Despite its outward health, Ecuador’s economy faces a host of home-grown challenges which could undermine its recent performance
Since his decisive victory in last September’s referendum on constitutional reform, Ecuador’s president Rafael Correa and his administration have had the wind in their sails.
Ecuador, like much of South America, is bounding ahead in key macroeconomic indicators. Per capita GDP is rising swiftly, jumping by $300 in 2007 and estimated to hit $3,500 this year. The Andean nation has the lowest inflation rate in Latin America, at 3.3% last year. Foreign exchange reserves have nearly doubled to $4 billion in the past year, and export earnings, which averaged around $880 million monthly, have been closer to $1.5 billion in the first two months of this year.
The staunchly pro-Correa constituent assembly, seated in late 2007 to rewrite the constitution, has meanwhile set about dutifully approving economic measures demanded by the government.
But while Ecuador’s economy is healthier than in many years, a number of issues have emerged this year which threaten to draw attention away from the country’s recent performance, while casting into doubt the stability sought by Correa’s administration.
Finance minister Fausto Ortiz, who has mounted a charm offensive in recent months to highlight the country’s economic turnaround, acknowledges that challenges lie ahead, but argues they are not home grown. “The principal risk is from external shocks, even though we are at a good place right now,” Ortiz tells Emerging Markets in an exclusive interview.
Ecuador is grappling with fallout from a border conflict with northern neighbour Colombia in early March, natural disasters in more than half the national territory caused by weather, and the downturn in the US economy, which has a special impact on Ecuador because it uses the US dollar as its official currency.
The prospect also looms that the country might lose its two decade-long preferential trade status with the US for more than 6,000 products. The legislation, known as the Andean Trade Promotion & Drug Eradication Act (ATPDEA), expires at the end of this year.
The threat within
But the prospect of domestically-sown discord also lurks, and one of the lingering doubts is the Correa government’s commitment to honouring its debt obligations. “Most of the outstanding bonds were issued by another administration, and there appears to be no institutional commitment to paying the debt,” says Ken Levine, an associate with New York’s Carter Ledyard & Milburn LLP, who follows Ecuador.
Ortiz’s predecessor, Ricardo Patino, announced in February 2007 that the country would delay a $130 million payment on its 2030 global bonds. The statement sent markets into a spin until Ecuador, surprisingly, then paid – a move which raised yet more questions about the government’s intentions. A video subsequently surfaced showing Patino discussing with investors the possibility of manipulating the debt market by announcing a moratorium/default and then complying with payments.
Ortiz is adamant that the administration has budgeted the money needed to cover the principal and interest payments on its debt – currently $13.8 billion. He denies the persistent rumours domestically and among foreign investors that Ecuador will tinker with the 2012, 2015 and 2030 global bonds.
“We have repeatedly said that in 2008 we would not do any kind of operation or approach the international markets for debt swaps, restructuring or new emissions, because the international markets differ greatly in their perception of us than what we know is our reality,” he says.
Ortiz says that Ecuador is considering approaching credit rating agencies and investors this year to begin laying the groundwork for new debt issues in 2009, though he says it is still too early to make definite decisions.
To some extent, such statements have helped ease doubts in some quarters after the country’s recent track record. But a year on from the Patino scandal, concerns about the government’s intentions persist. “Investors are certainly relieved to see that Ecuador currently appears to meet its obligations, but the country is so unstable politically that anything could change,” says Levine.
Taxing issues
At the same time, there are concerns over the government tampering with tax by upping windfall taxes for oil companies and proposing a windfall tax for the country’s nascent mining industry. “There have been a number of changes by the government to collect more revenue through taxes, which has some sectors alarmed,” says Hans Humes, of New York’s Greylock Capital Management.
But Ortiz says that such moves are part of a broader fiscal reform that has only just begun. “We have made advances with the tax structure, but there is still work to be done. We need to make things clearer and are examining the possibility of submitting additional legislation to refine the structure, but this would be at the end of the year or in 2009,” says Ortiz.
Tax reform was an early and constant promise of Correa, who was elected at the end of 2006. The principal push had been for a 2% decrease in the VAT tax from 12% to 10%, but that was scrapped for the elimination of a special luxury tax on phones.
Ortiz said the decision was made to eliminate the 15% special tax because it automatically meant more money staying in consumers’ pockets, but critics say it came about when the ministry finally recognized that a drop in the VAT would create a $400 million hole the administration would not be able to fill.
Oil funds
Ortiz draws attention to the scrapping of special petroleum funds and transferring the money from these accounts – close to $3 billion – to the national treasury. The state budget will increase to slightly more than $13 billion as a result. International reserves will also jump from $4 billion in February to more than $6 billion.
The additional money will be used for infrastructure projects, principally roads, hydroelectric plants and water systems. “We need to move ahead on infrastructure projects that past governments have neglected for many years. We need to build hydroelectric plants to change our energy matrix and dependence on oil,” says Ortiz.
Although Ecuador is an oil-producing country – two-thirds of its $1.5 billion in export revenue come from oil – it does not refine crude and has to re-import fuel used to generate electricity. One other project that could be covered by the oil revenue is construction of a refinery so that Ecuador would not have to continue importing fuel.
Analysts are encouraged by Ortiz’s early March announcement that Ecuador would repay Occidental Petroleum Corp. (Oxy) from a dispute over taxes. The final amount is expected to be around $170 million. Oxy won an arbitration case in 2004, but Ecuador appealed. The court, based in London, rejected Ecuador’s final appeal last November.
Oxy has a second arbitration process, this one with the World Bank’s international dispute centre, over a contract dispute that began during former president Alfredo Palacio’s government. The government cancelled Oxy’s operating contracts.
But other changes in the oil and mining sectors could cause investors to step back. The administration increased a windfall tax on oil from 50% to 99% in late 2007, and is currently negotiating contracts with foreign oil companies operating in the country. There is now a plan afoot to apply a 70% windfall tax to mining, which most analysts say would be a catastrophic move.
“In general terms, any windfall tax levied on mining would mean that the country and its nascent mining sector would be less attractive than other countries with more ‘miner-friendly’ attitudes. This would result in mining companies preferring to make any new investment in other countries than Ecuador,” says Mark Turner, Latin America equities analyst with Hallgarten & Company.
Ecuador’s mining sector is small compared to neighbours, such as Peru, but there are several big copper and gold projects worth several billion dollars in investment that might not come about if tax structures are changed.
Preferential state
Investors locally and abroad are increasingly troubled by the prospect of an end to the preferential US trade pact this year. But the government insists there is nothing to worry about. Ortiz reckons the US government is likely to renew the ATPDEA preferences, “because it is a compensation for our efforts to fight drugs”. ATPDEA was initially conceived in the early 1990s as a way to help Bolivia, Colombia, Ecuador and Peru develop legal economies as an answer to drug production and money laundering. The preferences have been repeatedly renewed, but the US government had hoped to replace them with free trade agreements this decade.
Negotiations began several years ago with Colombia, Ecuador and Peru, but only the Peru deal has been signed and should be implemented by the start of 2009. The Colombia agreement is at a standstill in the US Congress, and talks with Ecuador collapsed in 2006, partly because of the former government’s decision to cancel Oxy’s contracts.
Even if the US ditched the preferences, Ortiz says, the impact would be less severe than many believe. “Petroleum accounts for approximately 70% of our exports to the US, so the end of ATPDEA would not have an impact on this because there is demand for oil regardless,” he says. “There would be an impact on non-oil exports, and the country would have to find ways to address this.”