Whaaaat? Ecuadorian Bonds? From Ecuador? Call – yourself – an – analyst – you – are – joking – right – gimme – a – break – sure – to – default – at – any – minute – that – guy – Correa – a – raving – lefty – loony – mad – tree – hugger – pals – mini – Chavez – dictator – oil – socialism – business – investments – expropriate – S&P – Moody’s – junk – of – junk – rating – fleeing – pull – the – plug – country – communist – nationalize – everything – risk – wants – to – de – dollarize – look – at – the – country – risk – you – must – be – MAD!
Ok, now we’ve got all that out of the way, let’s examine the current situation in Ecuador and make the case for buying Ecuador sovereign debt.
The economy is doing alright
This basic fact is often overlooked by commentators and deserves better press, so here are a few facts and figures that give the pulse of today’s Ecuador. In the 2007 budget, the present administration guided to a GDP increase of 3.5% for 2007. This target has recently been upped to 4%. According to official central bank figures, non-petroleum exports are up around 10% YoY. Inflation is largely under control, with 2006 inflation at 2.87% and 2007 inflation not expected to top 2.9%. The dollarized economy is not subject to currency risks of any great import and tax collection is up both in absolute and percentage terms.
On the downside, unemployment stands at a stubbornly high 9.8%, debt an imperfect but manageable 25% of GDP, and although central bank reserves have risen from U$1.2Bn in 2004 to $2.5Bn in 2007 they still do not provide much of a cushion. Overall the macro stats might not grab as many headlines as Peru’s stellar numbers, for example, but all the same they are quite acceptable and certainly moving in the right direction.
Ecuador is now politically more stable than at any time in the last 10 years
In the last 12 months, via a series of smart political moves Rafael Correa has shored up his popularity and insulated himself from his political enemies. The recent constitutional assembly election (the outcome of which we correctly predicted) has cemented his power base with the population once and for all. At the same time his sworn enemies in Ecuador’s Congress have been totally outflanked and, effectively, left powerless to fight the traditionalist corner that Correa has railed against since coming to power. If Congress is not dissolved officially by the new assembly, it will either be given an indefinite leave of absence or simply ignored. Simply put, he has won his battle and can now concentrate on putting his plans into action, presumably standing or falling by his own future actions.
Correa may or may not promote your favourite ideology and he is not afraid to speak his mind, but those that wish to divide often jump to conclusions, rush them to press and preach them to the converted thus giving them an air of truth. Selectively chosen facts create an “us versus them” atmosphere that simply does not exist. As an example, those that are quick to point out his newly found friendship with Hugo Chávez of Venezuela are often ‘forgetful’ of Correa’s newly found friendship with Alan Garcia of Perú and the excellent relations both Ecuador and Venezuela have with its neighbour and “America’s Friend”, Colombia.
These are not minor details. International big business and finance can adapt itself to any form of political background; just take a look around and see. But it will run away from instability. Be it left, right or centre, after 8 presidents in just 10 years Ecuador needs political stability for growth more than anything else. Now that the September 30th vote has given him an effective mandate, we fully expect Correa to be the first president since the early 1990s to see out his full term in office.
The country has not defaulted in 2007 as feared
In February this year, much was made of apparent threats of bonds default made by Correa and his government team. Ratings agencies downgraded Ecuador and commentators lined up to explain when (not if) Ecuador would go to hell in a handcart. It didn’t happen. Correa’s government has made good on every single debt service. However eight months later people remain nervous, as bad news speculators shout louder and often remain in the memory longer than plain, simple, quiet facts.
Ratings agencies still have Ecuador debt in the deep junk area, with S&P for example rating the country paper at CCC (definition: currently vulnerable and dependent on favorable economic conditions to meet its commitments). However, a look at this year’s EMBI+ spreads shows 400 basis points have been shaved off since the February jitters and a full 200 points since the recent subprime scare.
Of course it isn’t S&P’s job to price risk, but those who actually trade bonds clearly recognize that Ecuador is not as risky as at the beginning of 2007 and has complied with world financial market rules. Ratings agencies almost always lag market sentiment, and from recent evidence its country ratings is due for an uptick.
Coffers swelling from new oil deals
Petroleum is the key part of Ecuador’s economy and by far its biggest export. In 2006, hydrocarbons exports were worth U$6.9bn, dwarfing the U$1.2Bn from Ecuador’s second biggest earner, bananas. Petroleum is forecast to haul around U$7.5Bn for the state in FY07. Correa has always made it clear that big oil would not be able to take the lion’s share of profits from Ecuador any longer, so last week’s announcement that the country will now take 99% of windfall profits on oil sales instead of the previous 50% might have surprised by its unannounced nature, but it is hardly out of character or a sudden departure from longer-term planning.
Correa’s government estimates that the move will swell government coffers by U$700m, a figure that could reach $830 if present high oil prices hold firm. But let us take U$700m as our benchmark number and give it some context. U$700m is 1.6% of 2007 estimated GDP. It is also around 25% of the amount needed to service Ecuador’s sovereign debt in the 2007 budget. In other words, in one fell swoop, Correa has bumped up GDP growth in real terms and has largely stopped any worries about debt default. Though there will always be some who decry the rape of big oil (tough for us to join that chorus), far from deteriorating the macro investment environment this kind of move improves the ability of Ecuador to service its debt to the satisfaction of the international community.
Reports from Ecuador this weekend suggest the decree passed by Correa was a type of negotiation position and that real deals will be thrashed out by energy minister Chiriboga in talks starting this week. Apparently, Ecuador would like the oil companies to move to service contracts for oil production which would leave the all oil produced as property of the country. Italy’s Agip Oil operates under this type of agreement in Ecuador, so there is already precedent for this type mutually satisfying agreement with foreign companies.
The bottom line to all this is that however the final deal is cut, Ecuador will benefit from extra revenue and those holding its sovereign debt should be ever more confident of servicing compliance.
Negative comments from the usual suspects
Predictably, those who would prefer Ecuador worried about foreign investors more than its own people were quick to denounce last week’s decree on oil profits. Of course there are many who opine to promote their own political agenda, but dubious opinions are not limited to those that don’t know where to find Ecuador on a map. As an example, when commenting on the oil decree, Alberto Ramos of Goldman Sachs noted to clients that,
“Unquestionably, this represents a major deterioration of the business and investment environment in the country and shows how aggressive the government is prepared to be in dealing with the private sector and in pursuing its nationalist inward-looking strategy,”
Call us picky, but there is something about the word “unquestionably” from an ex-IMF employee now working for big finance Wall St and talking about a country that rejects the IMF model that raises red flags. Since when have opinions about a social science such as economics had the right to be unquestionable?
Currently, Ecuador produces 530,000bbl/d of crude with state run Petroecuador responsible for a little over half that production. Of the approximate 250,000bbl/d produced by foreign oil companies, 190,000bbl comes from 4 companies, namely Repsol, Andes Petroleum, (a consortium majority controlled by PetroChina), Perenco and Petrobras, the balance being produced by smaller independents (e.g. City Oriente, Petrobell, Canada Grande, others). So far, only two of the companies involved have spoken about the issue. Repsol has said that they are not particularly concerned about the move and impact on the company would be minor. Petrobras has said that it wants to continue operating in Ecuador, it is willing to negotiate with the government and remains positive on its outlook regarding Ecuador production. Perhaps Repsol, Petrobras et al are playing a larger game and putting themselves in play for the 3.8 billion barrels of Ecuadorian oil reserves not as yet under contract, but for whatever reason the actual companies in the firing line seem to be taking a different view to this “major deterioration of the business and investment environment”. Mr. Ramos then highlights other sectors that he feels are at risk from his deterioration scenario, and includes the mining sector as one of those most at risk. This seems to contradict the opinion of Ecuador’s mining and energy minister himself, Galo Chiriboga, who said just last month that the country is pro mining with the caveat of social responsibility.
As a sidebar, we do believe that Ecuador will raise state burdens on the nascent mining industry to a level more akin to that of Bolivia (approx 50% total burden) than that of Chile (approx 35% burden) to name two examples. However, to assume that foreign mining companies aiming for commercial production in Ecuador will be scared off by a zealous bout of nationalization is absurd and smacks of fear-mongering, especially when the words of the minister in charge of the whole sector contradict the analyses in question.
What part of “Ecuador will not default” do you not understand?
Taking a look at the following chart we can see the Ecuador EMBI spread over the last 5 years has been either roughly equal or above (sometimes significantly above) today’s risk rate. But since the 1999 default on U$6.5Bn worth of Brady bonds that ended with the adoption of the US dollar as its currency, Ecuador has serviced its debt to the satisfaction of the international money market community. This is another one of those little facts often lost on people; through thick and thin and sometimes 4 figures basis points spreads, Ecuador has been a good payer. While Argentina imploded, 911 shook the world, and the Nasdaq bubble burst, Ecuador paid its dues.
Ecuador’s stated policy all this time has been to service its debt as long as they had the money to do so. We therefore believe it illogical (to put it mildly) to presume a sudden default now that state oil and other revenues are increasing, all on the back of GDP growth that outstrips inflation. Now add the fact that President Correa plans to alleviate the country’s debt load without having to resort to the dreaded default. After the recent win at the polls, Correa said last week (according to Reuters translation) “Yes, we will probably renegotiate debt using market instruments, buying back more expensive debt in exchange for cheaper debt.” With Correa planning to renegotiate debt next year the “friendly way” via swaps, we find the chicken-little attitude lacks evidence and is even harder to swallow.
Dependence on oil price for growth: A pretty good addiction!
Many analysts have made the connection between the survival and growth of Ecuador and the prices its oil is currently fetching at market. The argument amongst analysts, ratings agencies and financial houses goes that if oil suddenly sells off, Ecuador will be in serious financial trouble due to its dependence on black gold (59% of exports in 2006).
We agree. We also agree with the very same analysts, ratings agencies and financial houses who believe sub $60 WTI is about as likely as Nouriel Roubini making a bullish call on Toll Brothers next week. Incidentally, the same argument is made about Venezuelan bonds, so we would instantly recognize that the 600 point spread offered by Ecuador is a veritable bargain compared to the 400 point Venezuelan spread right now. What is more, couldn’t the very same argument be made of Peru? Or Chile? After all, their recent prosperity is clearly based on the rise in hard commodity prices. If copper suddenly sunk to 1999 levels, would you be re-pricing that risk? Currently, Peruvian bonds give a measly 120 basis points spread, so there’s about 5% per annum going begging over at the Ecuador pit!
In its 2007 budget, Ecuador balanced its books by benchmarking its average barrel at U$29. So far this year that oil averaged around U$60. With average barrels now selling at over $70, oil prices would have to deteriorate to such an extent that many other entities, not just the country of Ecuador, would be under serious financial strain. The bottom line is that Ecuador bonds may not be rock solid devices, but they do offer great value at this point in the commodities bull market.
Conclusion: Risk and Reward
We are not trying to make Ecuador out as some kind of Swiss bank. The debt rates at CCC, not AAA, and it is no-brain riskier to buy an Ecuador 2030 than a US T-10. That said, how are we to know post-CDO how much risk is really involved with those AAA bonds? At least with a sovereign bond the underlying numbers are open to investigation and relatively easy to analyze, putting them at a great advantage to the exotic/toxic mixes that have been packaged, tied with fancy ribbons and sold to certain European and Asian banks these last few years.
When it comes to sovereign debt it is ultimately a question of trust. There is no chapter 11 protection and to our knowledge creditors are not handed pieces of land by bankrupt countries as part of asset break-up settlements (well, not since the time of Charles II and the Penn family anyway). So the question is, “What does the sovereign debtor have to lose by defaulting?” President Rafael Correa has been elected on a socialist, left-leaning ticket. As far as we can remember, that kind of political viewpoint is one that tries its hardest to bring justice and prosperity to all sections of society, often concentrating its efforts on the poorest and most disadvantaged sectors. This president may sometimes talk tough, but he is also a qualified economist who understands the turmoil he as head of state would cause to his country if he defaulted, and whatever he might think of the capitalist system he has inherited it would be foolish of him to throw a tantrum and cause a major economic crisis. And Correa is no fool. We therefore see value in Ecuador bonds and recommend them as a buy at this point.
In an earlier publication, your author made a similar call on Argentine bonds. Despite drawing predictable flak, the Argentine EMBI spread is now 100 basis points lower than at the time of recommendation. However the reason for mentioning this call (apart from crowing slightly) is to point out that the same caveats apply; a position in Ecuador bonds should be made a medium term basis and not just bought-and-forgot. When properly monitored and managed, there is every reason to consider these high-yielding bonds as a useful and profitable part of one’s Latin American portfolio exposure.