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Emerging Markets

High price to pay?

Ecuador’s stance on its defaulted foreign debt could be a precursor to the end of dollarization. With the economy hurtling towards calamity, the government’s options are narrowing fast

In mid-March, Ecuador’s president Rafael Correa announced he will offer investors a foreign bond buyback plan next month – but one based on what he considers to be legitimate terms rather than on the value of the debt.

Correa, a left-wing economist, has led the Andean nation into default on 2030 and 2012 global bonds – with a face value of around $3.2 billion – after saying the debt was illegally issued by previous governments.

The firebrand Ecuadorean leader is now likely to offer investors tough talks over debt as the global financial crisis batters the country’s vital oil income. One view that is gaining weight suggests that the Correa administration’s approach to its debt – far from being an end in itself – is a likely precursor to the end of dollarization.

According to Alberto Bernal-Leon, head of EM Macroeconomic Strategy at Bulltick Capital Markets: “Correa has talked about default and the end of dollarization since the 2006 campaign. He has never liked dollarization, and I believe will end it shortly.”

Standing firm

Perhaps unsurprisingly, this view is dismissed by economic planning minister Diego Borja, who argues in an interview with Emerging Markets that such criticisms are aimed at undermining the government’s efforts to negotiate with debtors by raising fears. “There is absolutely no reason to fear that we are going to change the system,” he says. “We are dealing with economic vulnerabilities, but these are the same faced around the world.”

Borja has offered a national televised address and makes almost daily appearances on radio and TV news shows in Ecuador to reject assertions that president Rafael Correa’s administration will adopt a new local currency to replace the dollar. “The government has decided to defend dollarization because we believe that it contributes to maintaining real incomes of workers and, in the second place, right now we do not have the necessary infrastructure to have our own currency,” he tells Emerging Markets.

Although Borja admits that dollarization is coming under pressure as a result of the international financial crisis, including a steep drop in export earnings and reduction in remittances, critics say the problems are not external but caused by misguided government policy.

“Correa does not have a choice but to end dollarization if he wants to continue spending. The only way he can ensure access to enough dollars is to slash spending or prohibit all imports. He won’t do the first, and the second would collapse the economy,” says Bernal.

The Correa administration has responded to the threats to dollarization by trying to curb imports, increasing tariffs on more than 600 items and implementing import quotas on others. The goal is to close a trade deficit the government has said could top $3 billion in 2009. Ecuador posted a $497 million trade deficit in January, coming on the back of a $555 million deficit in January. The principal cause of the drop has been a decline in oil revenues, which were down 69% in January, to $288.75 million from $941.85 million a year ago.

“Given that Ecuador does not have its own currency, it lacks mechanisms to make imports more expensive through devaluation. We have no other choice but to increase tariffs and set import quotas,” says Borja.

Remittances, which were $3 billion in 2007, have been falling as Ecuadorians in the United States and Spain curb amounts sent home. These two countries account for 90% of remittances. Remittances were down 8% in 2008, and some estimates have them falling by 30% this year.

A second anti-crisis package aimed at the banking system is also meant to protect dollarization. After a meeting with the country’s banking association, the government announced in early March that it could invest approximately $800 million in foreign reserves in new banking instruments. The administration also lowered from 4% to 2% the amount of reserve requirements for banks as a way of increasing liquidity in the system.

Borja says talks with the banks, which will continue until mechanisms are defined, “would strengthen dollarization by increasing liquidity to productive sectors of the economy.”

Critics are not convinced, arguing that the government is only defending dollarization for political reasons until the April 26 presidential election that President Correa is strongly favoured to win. The vast majority of Ecuadorians favour dollarization in public opinion polls.

Spending spree
Alfredo Arizaga, who was finance minister in 2000 when former president Jamal Mahuad scrapped the sucre in favour of the dollar, says the external factors cited by the government are an excuse to mask policy mistakes. “Oil prices at $40 a barrel are double the historic price over the last decade, so the price of oil cannot be blamed for the problem. The root is a massive, irresponsible increase in public spending over the past two years that is rushing Ecuador towards a financial abyss,” says Arizaga.

The Correa government has been increasing spending at a rapid pace since taking office in early 2007. Arizaga says spending increased by more than 50% in the past year and predicted slower, but still significant growth in outlays this year. According to a report from the US-based Bulltick Research, government spending could increase by 21% this year, while revenues decrease nearly 6%.

A new 444-article constitution approved in September 2008 – Correa called early elections and is allowed to stand again in April because of the new constitution – could actually add more than $8 billion to annual spending if all of its provisions, such as universal health care and social security, were implemented as required. This is about double Ecuador’s foreign reserves at the end of last year.

Borja rejects the criticism, saying the administration has in place “a counter-cyclical policy for public investment and spending that will allow for growth this year. We should get though 2009 without too many problems.”

He forecasts GDP growth at a minimum of 2.3% in 2009, inflation near 5% and a budget deficit close to $1.5 billion. International houses have a less positive view, with Credit Suisse, for example, estimating a 1% contraction.

For now, most investors are focused on the Correa government’s foreign debt policies.

The issue of defaulting on bond payments was first raised in February 2007, and the Correa government has always been clear that its decision to pay is political and not economic, because it believes the debt was illegally incurred. In fact, Borja says that an international audit of the country’s debt concluded last year found “serious irregularities in the commercial debt.” Arizaga says the audit was a sham, “offering absolutely no evidence of wrongdoing. All this audit has done is damage Ecuador’s international image,” he says.

Kenneth Levine, a litigation attorney at Carter Ledyard & Milburn LLP advising clients on the default in Ecuador, rejects the idea that the 2012/2030 bonds were unfairly negotiated. “Ecuador had sophisticated advisers and probably the best legal counsel for sovereign issuers in the world. It simply has no basis now to walk away from the case, and bondholders would be foolish to take anything less than full value for those bonds,” he says.

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