The Curious Case of Ecuador’s Default – And Why It Matters

One of the questions concerning Latin America in 2009 is whether or not the region will be plunged into yet another dismal round of debt defaults as commodity prices stay low and foreign capital inflows frozen solid.

For the skeptics, Ecuador is Exhibit A.  In the context of a region that gave birth to the term “serial defaulter”, Ecuador’s mid-December decision to default on its bonded debt is an alarming development.

Unless you happen to own the bonds (and at this point only the most risk-addled investors probably do), ignoring the debt dustup in Ecuador is easy.   Hasn’t President Rafael Correa, that scourge of the neo-liberals, been itching to do just this for years?  Besides, the amount of bonded debt involved – $3.6 billion, at most, including bonds that Ecuador has probably repurchased – is not a systemic threat.  For the casual observer, the action by Ecuador has a sort of hard-to-fathom, out of the blue character.  After all, Ecuador was sitting on international reserves of $6 billion at the time it declared default, facing annual interest payments on the debt of less than $400 million.  In these circumstances, what really could be gained compared to the costs of default?

Tempting as it is to forget about Ecuador, what happens next there matters a lot for Latin America and for the world.  Why?  First, dollarized Ecuador really has managed to get its political and economic act more or less together in recent years, say what you will about President Correa.  Second, the financial pressures that comprise the default backdrop in Ecuador are similar throughout Latin America.  Every Latin American country faces tough choices about how to react to terms of trade losses and the sudden stop in capital flows.  Ecuador just happens to be one of the more vulnerable of the Latin economies and it may have in this case made a wrong choice.

We should not look upon the drama in Ecuador as morality play.  Yes, the government has argued that the debt is “illegal” and “illegitimate” on the basis of a government study which, it seems safe to say, would be unlikely to fare well in impartial international arbitration.  (President Correa, who is running for re-election in April, has warned the people of Ecuador to be prepared for painful retaliation from the international “monsters”, e.g., creditors.)  Putting moral considerations aside, this is about how the global credit crunch is harming the commodity-addicted and foreign capital-dependent economies of Latin America.

The bigger economic picture in Ecuador is clear – and very alarming.

First, Ecuador’s exports, mainly crude oil, but other natural resources as well, are collapsing.  Magdalena Barreiro of LatinSource Ecuador estimates that if current prices of $30/barrel for Ecuadoran crude oil (see graph below) prevail throughout 2009, the government stands to lose close to $3.4 billion in revenues compared to earlier budget projections based on higher crude prices..

Second, the vaunted international reserve coverage of Ecuador suddenly looks shaky and thin.  Since reaching a high point in mid-December of more than $6 billion, reserves plunged to $4.4 billion in just two weeks in December. (See graph below.)  The drop could be attributable to the government’s clumsy bond buyback effort, but certainly also it results from balance of payments setbacks.  Further declines from this point on in international reserves could risk setting off a run on some $12 billion in deposits in Ecuador’s banking sector as nervous depositors correctly perceive in the reserve erosion a proximate threat to dollarization.

Third, the external financing situation of the government in 2009 is challenging, to say the least.  Based on the most recent trends in fiscal spending, the government is looking at a financing need of more than $2 billion this year.  (This is assuming that a raft of new spending programs mandated in the new constitution are not funded in 2009, but who knows?)  While some of the financing needs could be met internally, Ecuador is going to have to raise significant funding abroad – perhaps as much as $2 billion.  And where will this funding come from in the wake of the bond default?  Maybe the IADB can provide some help, though that seems unlikely.  The word out of Quito is that Iran, Venezuela, and even Argentina could be approached.   In other words, Ecuador looks to be heading toward big fiscal trouble without a lot of good financing options.

Summing up, Ecuador presents many elements which in another context led to the collapse of convertibility in Argentina in 2001.   Exports, not just crude exports, are falling fast.  (The U.S. is the major market for Ecuador.)  The government has no access to private lines of credit, no foreign investment to speak of, reserves which are being rapidly depleted, and government financing needs which are very large and likely to grow.  Now add to this toxic mix a panicky run on deposits in the banking system and a scenario suddenly appears of an abandonment of dollarization followed by furious running of the printing presses to produce massive amounts of a new domestic currency.

Oddly enough, the Correa government may not find this scenario of de-dollarization (and implicit domestic default) all that frightening, though they would prefer it to occur after the April elections, naturally.  Correa and other government officials have talked openly about shaking off the monetary and credit constraints imposed by a dollarization scheme which they inherited.  They may be thinking now that they need the ability to create domestic liquidity in 2009 to bail out the government and the private sector, including the banks.

Yet the rest of Ecuador probably sees this scenario of a collapse in dollarization with enormous concern.   The same opinion polls that show Ecuadorans in favor of external debt default find that 80% of the population favors keeping the dollar because it has brought a measure of stability to a once deeply troubled economy by protecting their own assets.  Yet this confidence on the part of the public has to be seen as fragile, as a banking sector scare in December illustrated clearly.

Maybe dollarization can be sustained through the April elections, but if the adverse global trends continue, for how much longer after that, assuming President Chavez cannot or will not ride to Ecuador’s rescue? And if dollarization succumbs to the crisis, who is to say how severe the subsequent crisis of unemployment and falling real incomes could be in Ecuador?    The Argentine economy plunged by 13% in the first year following the exit from convertibility.

I do not think it is worth the risk of waiting to find out how bad things could be in Ecuador.  The truth is that global trends battering all of Latin America have backed Ecuador and some of the weaker economies into a tight corner.   Some of these economies, or most of these, need some sort of global help – a lender or spender of last resort, emergency lines of credit – to weather the storm.  Few of these economies, if any, have the ability to manage their own ways out of the crisis which has befallen them.

If pride and politics can be pushed aside, the wiser course for Ecuador and for the region would be to find some face-saving way to put the default genie back in the bottle and to seek some sort of international assistance in the form of arbitration and backup lines of credit, with a nod from the Obama administration.  That could provide needed short-term support for dollarization which has been very positive for Ecuador.

True, Ecuador may have burned some needed bridges (to the IMF, for example) and it may have made a decision to default that is difficult to understand, but that does not mean the global community should be indifferent to its fate as a small Latin American economy  deals with the effects of a global crisis not of its own making.


11 Responses to "The Curious Case of Ecuador’s Default – And Why It Matters"

  1. sim   January 9, 2009 at 7:24 am

    The default is not very “difficult to understand” from here in Ecuador. The debt in question was accumulated by governments that, under international pressure, followed the 1990s neo-liberal model which, instead going to public projects, led to economic collapses. The press has been sounding the alarm that Ecuador will be cutting off its access to international credit, but before, when they had access to huge loans, the public only felt negative consequences. It is no wonder they voted for a non-payment platform; if that alarms the international investor class, then in the future they should ensure that their investments benefit more than the corrupt upper classes. Otherwise a whole lot of other little countries might decide to stand up for themselves too – imagine that!

  2. Guest   January 9, 2009 at 10:41 am

    Sim: if ecuador and other small countries “stand up for themselves”, where will they get the money they need when facing hard times? there’s no such thing as a free lunch. in other words, every action always has some painful consequence. the question then becomes which action has the least painful consequence. is default the best action? this seems to overall have the more negative consequences than not defaulting. don’t let personal ideology and emotion get in the way of doing what is best for the largest amount of people over the long term.

  3. Anonymous   January 9, 2009 at 1:27 pm

    There is no way Ecuador can de-dollarize. Ecuadorians are still traumatized from the 1999 banking crisis, a new currency would fail before it even began. Say for example Correa implements a domestic currency right after the April elections – sure Correa can decree whatever he wants. However, it would be obvious to almost everyone that it was a printing press scheme. Do you think anyone would save in local currency? No, right after they got their wages they would go to the street and change them to dollars. Similarly if I’m selling a car or building a house the quote would be in dollars, not the local currency. No domestic investment would happen in the local currency. For all intents and purposes, the economy would still be dollarized. The ones who would suffer would be the poor and rural Ecuadorians suckered into local currency wages. Correa can connect these dots.Ironically, dollarization will be Ecuador’s saving grace. Gone are the traditional, politically expedient options of monetary expansion and easy credit access. Correa will be forced to focus on productivity. While enormously painful, Ecuador will have no choice but to modernize aand streamline. Anyone who has spent some time here knows Ecuador is one of the most inefficient places in the world. For all of Correa’s maddening traits, I then he gets that part.

  4. JaimeKR   January 9, 2009 at 6:44 pm

    Ecuadorian fiscal position isn’t as hopeless as that of Argentina in 2001, there’s still room for maneuvering if there’s political will for cutting the huge amount of subsides on fuel, that takes USD3-5 billion from fiscal budget. There’s also room for shrinking a lot of current spending without substantially hampering the whole economy because the spending spree is just two years old. Dollarization was fully sustanaible 4 or 5 years ago with oil barrel prices just as “low” (I quote “low” ’cause by then that price was seen as “high”, after going as low as 1-digit figures at late ’90s) as now. What’s lacking is the political will for taking those steps, no doubt they’d be painful, but not as much as de-dollarization.P.S.: Sorry for my bad english

  5. Tambopaxi   January 10, 2009 at 11:10 pm

    I agree with Trebat; defaulting on the interest payments on the 2012 bonds was a mistake. It may have been a politically and emotionally gratifying move but financially speaking, it’s going to have negative reprecussions, and in fact, they’re already beginning to be felt.The GOE’s 2009 budget is in real trouble, its reserves are taking a beating, and not surprisingly, the GOE is having trouble in scraping up new capital, notwithstanding optimistic remarks by MinFinance Viteri and Pres. Correa regarding possible loans from the IDB, CAF, etc. All of this places pressure on a dollarized economy to become more productive, increase competitive imports, etc., as Anon. 13:27 correctly points out. On an emotional level, Correa would love to de-dollarize since he’s never liked dollarization, but he knows that doing so would probably mean the end of his government since the vast majority of the people living here in Ecuador (including me) don’t ever want to see the inflationary instability of the late 90’s again.Yesterday (Jan. 9) Correa announced that he’s taking $700 million from the Social Security System here to finance government ops, and he’s doing it as a simple transfer from IESS accounts to the government with the acquiescence of Correa-appointed IESS board directors. No word on how/when those funds might be paid back to IESS depositors (including me), but it’s clear that Correa is cleaning out the cupboards to keep GOE ops going and that he’s having a difficult time doing so. I can only hope that Correa can find, as Trebat posits, some way of putting the default genie back in the bottle so that we have a better chance of getting credit here….

  6. Luciano   January 14, 2009 at 6:06 am

    “We should not look upon the drama in Ecuador as morality play. Yes, the government has argued that the debt is “illegal” and “illegitimate” on the basis of a government study which, it seems safe to say, would be unlikely to fare well in impartial international arbitration.(President Correa, who is running for re-election in April, has warned the people of Ecuador to be prepared for painful retaliation from the international “monsters”,e.g., creditors.) Putting moral considerations aside, this is about how the global credit crunch is harming the commodity-addicted and foreign capital-dependent economies of Latin America.”This is the most important thing here. Its all about moral. The big fish eats the small fish. The only thing that prevents that is moral. And it is also moral that would prevent future finantial crises. And Correa message is to bring the moral issue to the table.

  7. RL   January 16, 2009 at 3:28 am

    not of his own making? give me a breakCorrea has made a great effort to make the economy more oil dependent more fiscaly imbalanced and less investor atractive during bonanza years. Instead of acumulating a surplus or investing in creating a more productive economy over the past years Ecador has done everything in its hand to be as vulnerable to the global downturn as possible. And now they will try to blame it on “neoliberal” policies of the past and the high debt!! Sad

  8. Guest   January 16, 2009 at 7:53 am

    Mr. Trebat,Why do you think Ecuador decided ti pay the coupon of the Global 2015, despite that this bond was also considered “ilegal and illegitimate”?I see this government full of inconsistencies…

  9. EB   January 19, 2009 at 8:24 pm

    Very clear and correct analysis, I believe. For RL and others, the morality point of view should consider those thousands of Ecuadorians which will lose their jobs and incomes, not only due to the international crisis, but mainly because of the careless “moral” position of Correa’s government. As the second comment correctly points out, an optimal decision – whether from an ethical standpoint, or a pure economic one (whatever that means) – should probably take into account the consequence which bares greater benefits to a greater amount of people. Or even, if gini-coefficient observers are wary, which decision will most help the poor and needy society in Ecuador. I guarantee you, by any of these 2 criteria, Ecuador’s Government is handling matters in the wrong way, and it should have paid its debt.

  10. RL   January 21, 2009 at 7:39 am

    EB, I agree with you: I do not oppose and assistance package to Ecuador. It should be done if necessary to avoid the terrible social consequences if the economy collapses. Still, it’s necessary to set the record straight. It seemed to me that the otherwise excellent article puts the blame of Ecuador’s problems on external factors when, if they go bankrupt, we should look into their unsustainable policies.

  11. almacas   February 12, 2009 at 11:37 pm

    Many times the root causes of a problem are not as simple as they first appear. However in this case I believe they are very simple and straighforward. The first problem with Ecuadorian policies is the lack of institutions that secure free market policies. This inability to have clear rules and systemic corruption at the bureaucratic levelcontinue to make foreign investment very unatractive and has a chilling effect at such a volatile time. No CFO worth his/her salt would think of investing in a country with such a promise of lack of stability. I agree with RL that Ecuador should look at itself and its polititians rather than banks or any otuside factor to the root of their problem. While it is true that international financial system is incrisis mode, that is not the sole reason for Ecuador’s problems today. Correa in his unbridled populist ambition has decided to invest in unsustainable social programs which will diminish whatever reserves the country has and will force the small economy to borrow from foreign investors at a time when its credit worthiness is in question. Does anyone else see the lack of understanding of basic economic principles here? At at time when Ecuador should lower taxes Correa has added tax burdens to the people of Ecuador. Perhaps he fails to see the connection between higher taxes to small and medium size employers increases unemployment and less tax revenue. I don’t buy the morality argument. It is an old argument in Ecuadorian and Latin American politics and it looks to place blame for its inability to create economic growth on outside factors, whether it be the IMF, the US, and any other possible culprit, but never its internal policies.The way I see it, Correa, Gutierrez, and any other previous presidents have had opportunities to create needed structural changes and join the international economy. They have failed,and instead joined ranks with Venezuela and Bolivia. Sadly the Ecuadorian lower, lower-middle, and middle class will pay the price. I hope this doesn’t create real political unrest. That is the last thing this small economy needs.