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Ecuador, here represented by capital Quito, plans to sell around $700 million in bonds in the open market in the next few months. (Photo: Asociación de Municipalidades Ecuatorianas)
Wednesday, May 7, 2014

Ecuador: Bonding vs Bondage

It isn't feasible for investors to buy new Ecuadorean debt if the government doesn't mend ties with the IMF.


Among Ecuadorean ongoing financial debates, the question of whether president Rafael Correa would eventually attempt to return to the global financial market has trailed only the question of whether he might try to replace the dollar with a local currency in importance.

After all, nothing during his seven years in power has done more to establish his credentials of economic unorthodoxy than his decision to a political default on the $3.2 billion in foreign debt that he – not a court – determined to be “illegal” and “illegitimate.” He continued serving only the $650 million in 10-year bonds maturing next year (the “2015s”) in whose issuance, which had some legal trouble, he played an instrumental role. In comparison, his breaking of ties with International Monetary Fund, the monster in the closet of unorthodox economists, was a cheap thrill: Ecuador only owed the Fund $11 million. When repaying that final amount, he said that "We don't want to hear from that international bureaucracy ever again."

Over the past 18 months, Correa has however moved to placate significant foreign financial institutions that he previously derided. This has included the Financial Action Task Force (FATF), a global organization that sets standards for combating money laundering, the World Bank, which has resumed lending, and international credit ratings agencies. Now, he has announced his wish to sell around $700 million in the open market in the next few months.

If done properly, this could do a lot of good for the economy. It could improve transparency by providing data on liabilities taken on with China and the domestic, state-run social security service IESS, and provide a debt yield curve and a benchmark for domestic debt and corporate loans from foreign sources. For some analysts, Ecuador missed the boat taken by the likes of Bolivia, Honduras, and Paraguay in the region last year. But to tap markets this year still makes sense, given that interest rates remain relatively low. It will certainly be more expensive to wait another year. It remains highly questionable, of course, that Ecuador will manage to place any debt at less than the rate paid under bilateral loan commitments with China, i.e. around 6 percent, not including further costs such as paying back loans in oil. To ask for around $700 million looks a relatively safe bet if Ecuador wishes to place the debt and have solid demand, albeit at rates that will still reflect this country's elevated risk. This will also require careful consideration of a number of technical issues.


Holders of the 2015s first off look to be the natural candidates as buyers for the fresh issuance, continuing to enjoy high coupons and, since last February's local elections, with the much brighter prospect of a more market-friendly administration once Correa’s term expires in 2017. It's unclear at this moment whether holdouts from the 2009 buyback of the bonds due 2012 and 2030 will manage to mount a challenge. Ecuadorian officials and potential investors alike will want to observe the precedents the legal dispute in the US between Argentina and its holdouts from its world record 2001 default might set.

In the case of Ecuador, some 95 percent of bonds were bought back at 35 percent or less of the face value in 2009, according to information given at the time that the government hasn’t made fully transparent. (If the debt was truly illegitimate, it is odd that the government actually went ahead with a buyback.) Among the remaining holders of 2030s, some have apparently received the slightly less painful reward of another five points (40 percent) from the administration via a European investment bank. Thus, the number of holdouts interested in forcing Ecuador into the courts on this matter appears to be sinking. It could also consider exercising its call options on the bonds that it couldn't buy back. Media report that the administration has lined up Citibank and Credit Suisse to lead the potential issue. During his visit last week to the US (see below), he met representatives of investment banks in New York City, including Goldman Sachs, Credit Suisse, Darby Overseas, and Blackstone, according to the presidential office. According to our sources, the president was disappointed with the interest rates potential investors asked for.

Domestically, Correa will have to explain the about-face on sovereign debt, which he will certainly do by claiming that this time around, the debt will help the people, and not the bankers. The administration will officially book the money as funding for the continued rollout of road repaving, modern schools, power plants, and other infrastructure projects. The issue of international arbitration will arise, while hyperbole abounds in the sales pitch: Correa said that the World Bank has made available a $1 billion because it “is behind us to place funding with us, because they admire the country’s growth.” In fact, the increased availability of credit is available for all developing countries, as World Bank president Jim Yong King said on April 1. And the money will be used for individual projects, particularly for municipal water supply and sanitation, rather than providing support to the central government budget.

Hyperbolic comments, as well as Correa’s acknowledgement that Ecuador will require a whopping $9.5 billion this year alone in loans, a stunning figure considering it’s about 10 percent of gross domestic product, must be reviewed in the sales prospectus. As late as last October, the government said it needed "only" $7.6 billion in the 2014 budget; at 25 percent more, this latest figure goes well beyond the 15 percent increase the government can ask for without asking congress for permission.

It would also increase debt to around $30 billion in total (domestic and foreign) considering about a third would go to paying off debt, and thus raise total debt to a bit below 30 percent of GDP. In the budget proposal, the government didn't expect to approach the constitutional limit of 40 percent until 2017, the final year of its term, but at the present rate, this will likely happen much sooner, if it manages to receive the financing it wants. Investors will need to vet whether the prospectus for the new bonds adequately reflects risks, while the administration has done the utmost to keep accounting hidden from scrutiny. If done properly, a review will potentially map the politically and economically charged blank spots of central bank, finance ministry, and social security balance sheets.

Crucially, it isn't feasible for investors to buy new Ecuadorean debt if the government doesn't mend ties with the IMF and accede to the in-depth "Article IV" macroeconomic reviews that all members are subject to. It also must do this if it wants to be prepared for the eventuality of a balance of payments crisis, during which the IMF could be asked for a contingency or standby loan. This would be economically and politically smarter than insisting on reducing imports, the current policy. Sadly, this may yet be too much for Correa to bear.

This commentary originally appeared in Ecuador Weekly Report published by Analytica. Republished with permission.

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