ECUADORIAN FISCAL POLICY: LIVING ON THE EDGE

C O N F I D E N T I A L SECTION 01 OF 07 QUITO 001181 SIPDIS DEPT FOR WHA/AND TREASURY FOR GIANLUCA SIGNORELLI E.O. 12958: DECL: 05/20/2010 TAGS: EFIN ECON EC SUBJECT: ECUADORIAN FISCAL POLICY: LIVING ON THE EDGE REF: A. QUITO 900 ¶B. QUITO 1054 ¶C. QUITO 1159 Classified By: AMBASSADOR KRISTIE KENNEY, REASONS 1.5 (B,D) ¶1. (C) Summary: Minister of Economy and Finance Rafael Correa inherited a relatively responsibly-managed fiscal situation from his predecessors. If he continues their policies, he should be able to meet his budget without great difficulty. However, his early statements to the press have damaged Ecuador's financing prospects while increasingly the likelihood of resource demands from powerful sectors of the economy. Most significantly, Correa is asking Congress to reform the fiscal transparency law, placing the funds accumulated in the FEIREP (petroleum stabilization fund) into the budget. Our best guess is that, after raiding the FEIREP, he faces a financing gap of some $230 million for this year, if the International Financial Institutions (IFIs) disburse, a sum which could be dealt with as budgetary arrears. However, the gap could approach $1 billion if Correa fulfills some of his more rash promises. If the situation heads in that direction, the probability of default, a solution Correa has an ideological preference for, will certainly increase. ¶2. (C) We continue to believe that IFIs (World Bank, Inter-American Development Bank, Andean Development Corporation) should strike a firm stance with the Palacio government, demanding responsible policies if they are to disburse. We also believe that Palacio needs to hear, as often as possible and from as many sources as possible, what the likely consequences of default would be. The only two Latin American governments to default over the last ten years lost power shortly afterward. End Summary. ¶3. (U) We have met with numerous informed parties over the past two weeks to discuss likely fiscal prospects for the GOE. In meetings with the IMF resrep, IBRD, IDB and CAF representatives, the staff of the Fiscal Policy Observatory (a UNDP project),former Ministers and Deputy Ministers of Finance, some 15 visiting Wall Street analysts, and Ecuadorian bankers and businesspeople we found widely varying prognostications, but some common themes. From these contacts we have compiled several scenarios for the GOE budget for the remainder of 2005 (see below). Although a variety of differences of opinion and assumptions about the situation and GOE policy mean that projections of the financing gap vary widely, it is clear that the situation has gone from substantial over financing under the former government to a real risk of default. While we believe default is not the most likely scenario, it cannot be ruled out. Following is our analysis of the key points in the scenario. The Background ¶4. (U) With record-high oil prices, Ecuador should be rolling in oil cash. It is not. There are several reasons for this, ranging from the profligacy of previous governments which left the GOE with high debts and exorbitant salary bills, to structural problems including the huge subsidies the GOE pays and heavy earmarking of revenues. Perhaps the most important drain from Ecuador's oil windfall is its fixing of prices for petroleum derivatives, in effect a costly subsidy. ¶5. (U) Since the GOE, through Petroecuador, markets petroleum products at fixed prices well below market prices, when oil prices increase, Petroecuador's losses from these sales counterbalance a good part of its earnings from the sales of crude. In the above table, this is visible in the "sales of products" line under "petroleum," where we are projecting a loss of some $450 million from amounts projected in the budget. These losses actually outweigh the gains from the increase in the oil price, for a net loss of close to $300 million dollars. Of course, these figures ignore the FEIREP (petroleum stabilization fund),which we expect to collect some $670 million, an increase of $129 million. Thirty percent of the FEIREP was included in the budget, so new FEIREP revenues amount to almost $50 million. (See below for more on the FEIREP.) ¶6. (U) Other important changes in actual revenues include an increase of more than $100 million in tax revenues. This is the result of substantial increases in imports and the resultant customs duties in the first quarter, though the increase is expected to moderate as the year proceeds. Under Yepez there was an expectation that he would under-execute outlays, which is traditional in Ecuador, which could have been expected to cover much, if not all, of the $114 million shortfall. In any case, Yepez also had realistic hopes of accessing foreign markets in a significant way, which could have also been used to cover any shortfall. 2005 Budget Scenarios - Gutierrez Government By Law Yepez Likely Total Income 5432.6 5318.6 Taxes 3186.7 3306.7 Petroleum 1531.5 1249 Exports 781.6 943 Sales of products 749.9 306 "Stabilization" (20% FEIREP) 98.4 134 "Health and Education" (10% FEIREP) 54.1 67 Autogestion 561.9 561.9 Total Outlays 5918.2 5918.2 Primary Outlays 5065.5 5065.5 Salaries 2182.4 2182.4 Goods and Services 391.9 391.9 Transfers 926.2 926.2 Other current outlays 36.7 36.7 Financial Investments 14.2 14.2 Capital 1514.1 1514.1 Primary Surplus 367.1 253.1 Interest 852.7 852.7 Deficit -485.6 -599.6 Financing 485.6 485.6 Net Credit 504.3 504.3 Disbursements 2248.4 2248.4 Amortization 1444.1 1444.1 Adjustments 18.7 18.7 CETES (due) 300 300 Income and Disbursements 7681 7567 Outlays and Amortization 7681 7681 Financing Gap 0 114 The New Situation -------------- ¶7. (SBU) The three scenarios detailed in the table below are based on Minister of Finance Correa's oft repeated statements regarding use of the FEIREP within the budget. It is important to note that these three scenarios are unrealistic in several ways (which will be discussed below). First, all three assume substantial disbursements by the IFIs, whereas those disbursements are only likely if the first (and least likely, we judge) of the three scenarios is implemented. Second, they do not take into account substantial rollover risk. Third, none of these scenarios take into account any significant response to the fiscal pressures which have been unleashed by the Minister's statements. Finally, the third, and even the second, scenario may assume more management capability than is present in the GOE. In fact, the GOE may not be able to expend resources as quickly as Correa would like. Raiding the FEIREP -------------- ¶8. (SBU) A raid on FEIREP resources is the basis for much of the new minister's plan. The FEIREP, a petroleum stabilization fund, was established in 2002. By law, GOE earnings from heavy oil production are to go into the FEIREP. The FEIREP is then to be used 70% for debt buyback, 10% for education and health spending, and 20% for "stabilization." From his early statements as Minister, it is clear that Correa believed that moving these funds into the budget would allow him to substantially increase GOE spending in the current year. Just as clearly, he has been sorely disappointed on this score. ¶9. (SBU) In fact, while carefully adhering to the letter of the Fiscal Transparency Law which established the FEIREP, former Minister of Finance Mauricio Yepez had already done violence to the spirit of the fund. The 10% of the fund intended for social spending (and, presumably, for increased social spending),had been used for current education and health spending, freeing up resources for other uses. The 20% for stabilization, presumably meant as savings in good years to balance against years when oil income was lower than average, had been dropped directly into the budget (to "stabilize" it). However, the real centerpiece of Yepez' financing was "laundering" the remaining 70% through the Social Security fund (IESS) in order to use it to finance the deficit. In 2004, all of the 70% was used to buy back debt from IESS, which then immediately bought new debt from the GOE, thus financing the budget. Yepez planned the same destination for this year's 70%. ¶10. (U) Estimates of the funds available in the FEIREP this year vary widely (from $600 million to $900 million, compared to $541 million used in budgeting). We choose to use a $670 million figure which comes from former Vice Minister of Finance Ramiro Galarza. This is substantially higher than the number the Fiscal Observatory is using ($600 million), but less than some other estimates (including that used by Correa). ¶11. (SBU) Correa's plan for changing the FEIREP, apparently announced before he knew that his predecessor already intended to use the fund for budget finance, may substantially impact the fiscal sustainability of the budget. Correa announced that another 20% of the fund would go to social spending, for a total of 30%, 10% would go to science and technology, and 40% would go into "economic reactivation" or, if deemed useful, debt buyback. Continued RELATIVE Responsibility -------------- ¶12. (SBU) The three scenarios laid out in the above table illustrate three very different uses to which Correa could put the FEIREP. In the "Conservative" option, all $670 million from the FEIREP is used for budget financing (actually, 60% enters above the line, while 40% could be above the line or could be used for a "laundering" operation similar to that used by Yepez in 2004 - the net effect is probably the same, though it would be subject to the rollover risk issue identified below). In this scenario, Correa continues the shell game his predecessor began, saying that 30% of the FEIREP is being used for social spending, for example, but using the funds to cover spending which was already planned under Gutierrez, rather than making any spending increases. ¶13. (C) We judge this scenario to be unlikely. Correa and Palacio entered their current positions after years of criticism of the fiscal restraint of their predecessors. It will be politically difficult for them to so obviously renounce their beliefs. In the case of Correa, his whole academic career has been based on the idea that the state needs to serve as the engine of growth, and it may be intellectually impossible for him to implement the economic policies of the "crazy bird" or Woody Woodpecker Ministers of Economy who preceded him (to use his description). That said, this policy does offer the opportunity to reduce the financing gap to a perfectly manageable $33 million. Splitting the Difference -------------- ¶14. (SBU) In the second scenario, Correa would increase spending by some $200 million, most likely targeting science and technology for some $67 million in new spending (ref c), and putting another $133 million into healthcare and education. In this option, Correa would use 40% of the FEIREP funds ($268 million) for financing via the IESS debt buyback "laundry." ¶15. (C) Although the resultant financing gap of some $234 million is probably manageable via some combination of underexecution and arrears, we believe it is likely that IFIs would be unconvinced by this option, and would opt to cut their disbursements by some $200-$300 million. At a level of $500 million, the financing gap is a serious problem, and could force a decision between paying salaries or paying debt. Still, we judge this scenario most likely, as we believe it gives the Palacio government political (and, for Correa, intellectual) cover, which they perceive they need. Party Hearty, Rafael! -------------- ¶16. (C) This middle-of-the-road scenario is, however, clearly not the preferred option for Correa, because, as he sees it, government spending would not increase enough to stimulate economic growth. Correa firmly believes that, "with one hand tied behind its back" as a result of dollarization (no monetary policy),Ecuador must use fiscal policy to spur on the economy. He has argued at length in his academic writings that fiscal and monetary policies geared to keep inflation low are inappropriate to developing countries, and that inflation levels of 20-30% are optimal. He will want to spend. ¶17. (C) The third option has him adding the remaining 40% of the FEIREP to above-the-line revenues and spending those funds on schemes intended to stimulate production. In particular, he has been talking about using state institutions (including Pacific Bank, owned by the Central Bank as part of the still-unresolved aftermath of the 1999 banking crisis) to lend at subsidized interest rates, especially as micro-finance. This policy would take the financing gap to an unsustainable $500 million, and since the IFIs are almost certain to withhold disbursements under this scenario, the financing gap would most likely approach $1 billion. 2005 Budget Scenarios - Palacio Government Most Conservative Likely Preferred Total Revenue 5787.6 5787.6 5787.6 Taxes 3306.7 3306.7 3306.7 Petroleum 1249 1249 1249 Exports 943 943 943 Sales of products 306 306 306 Total FEIREP 670 "Stabilization" (20% FEIREP) 134 134 134 "Health and Education" (10% FEIREP) 67 67 67 Correa FEIREP 469 469 469 Autogestion 561.9 561.9 561.9 Total Outlays 5918.2 6119.2 6387.2 Primary Outlays 5065.5 5065.5 5065.5 Salaries 2182.4 2182.4 2182.4 Goods and Services 391.9 391.9 391.9 Transfers 926.2 926.2 926.2 Other current outlays 36.7 36.7 36.7 Financial Investments 14.2 14.2 14.2 Capital Expenditures 1514.1 1514.1 1514.1 Correa FEIREP ($670 mil.) 0 201 469 Economic Reactivation (40%)0 0 268 Science and Technology (10%) 0 67 67 Social Investment (20%) 0 134 134 Primary Surplus 722.1 722.1 722.1 Interest 852.7 852.7 852.7 Deficit -130.6 -130.6 -130.6 Financing 97.1 97.1 97.1 Net Credit 115.8 115.8 115.8 Disbursements 1859.9 1859.9 1859.9 Amortization 1444.1 1444.1 1444.1 Adjustments 18.7 18.7 18.7 CETES (due) 300 300 300 Income and Disbursements 7647.5 7647.5 7647.5 Outlays and Amortization 7681 7882 8150 Financing Gap 33.5 234.5 502.5 Entering La La Land -------------- ¶18. (U) Readers may be wondering whether the batteries in our calculators are running low to even consider the possibility that the GOE would intentionally implement such a blatantly irresponsible policy. We assure you that our analytical abilities have not been affected by the altitude. Rather, we are concerned that Correa, Palacio, and even Ecuadorian society at large, far from repelled, are attracted by the siren song of default. ¶19. (C) Both Correa and Palacio suggested, in their first days in office, that a "political renegotiation" of Ecuador's foreign debt would be a benefit to the country. One of Correa's first acts upon arriving at the Ministry was to request development of scenarios for default (ref a). He has threatened IFI representatives that he would continue paying Ecuador's debts to their institutions "as long as you keep disbursing to Ecuador." In conversation with EconCouns three months ago he lauded Argentina for its default and later suggested to an audience that this was an example Ecuador should follow. ¶20. (U) Not that his audience would disagree. For years now the drumbeat on the impossibility of Ecuador's meeting its debt burden has been constant, and we have hardly met an Ecuadorian who does not believe that paying the debt (understood by the man in the street to amount to 40% of the GOE budget) is an impossible task. Nevermind that more than 50% of the GOE's debt payments are domestic, mostly to the IESS. As a concept, default is very popular in Ecuador, and very few Ecuadorians understand what its likely consequences would be. If the default is blamed on the IFIs, and especially the IMF, which are refusing to finance the government because it is prioritizing social welfare above the profits of the evil debt holders (as we expect it would be),the populace would be ecstatic. Although we continue to hope that Ecuador will step back from this brink, we do not rule out the possibility of default. Making Matters Worse -------------- ¶21. (U) Still, we have not concluded this gloomy picture. First, we need to consider new fiscal pressures. Then, rollover risk and the prospect for new financing. Gimme, Gimme, Gimme -------------- ¶22. (U) As the tables demonstrate, almost 45% of the GOE's primary outlays are salaries. These are re-negotiated every year in painful processes, usually accompanied by strikes. In the last 18 months, teachers, state oil workers, state health workers, numerous ministries, and judicial employees have all gone on strike for higher wages. Teachers were already demanding wage increases amounting to $120 million for 2006 before the change in government. It is only reasonable to expect that teachers and health workers, at least, will demand that part or all of the new funds Correa is promising for their sectors for 2005 go to salary increases. Petroecuador employees recently received an 8% wage increase, retroactive to January 2003, which the Palacio government has announced it will not challenge. Other government entities are sure to follow this lead. This decreases still further the prospect for implementation of the "conservative" scenario. ¶23. (U) More immediately, it is a sure thing that the wage bill in the tables understates the actual bill. Public sector employees have been granted increases in wages for this year as part of a long-term effort to standardize wages across the various ministries and agencies. Yepez intended to keep these increases from affecting the wage bill by laying off employees (and had an IFI loan in place to pay their severance pay). Only Ministry of Finance workers had been laid off when the Gutierrez government fell. Correa has announced that, in a country with 12% unemployment, it would be "insane" to lay off public sector workers. We don't yet have an estimate for the fiscal impact of the failure to lay off unnecessary employees. Rollover Risk -------------- ¶24. (C) Another problem which may face the Correa team earlier, rather than later, is the likelihood that a significant number of the holders of Ecuador's domestic debt will try to get rid of it. There is no secondary market in GOE domestic debt, so it is not possible to judge accurately market sentiment. However, the analysts, and a few holders of domestic debt, we have talked to have suggested that a significant portion of the private holders of debt, maybe 50%, will want to unload. (Proving that we weren't the only ones listening to Correa's morning TV show pronouncements.) Banco de Guayaquil President Guillermo Lasso said that "you would have to be mad to hold onto GOE bonds." And he should know, since his bank has a few. ¶25. (C) At $450 million, private holders make up about one third of the debt the GOE needs to roll over in 2005. Former Deputy Minister of Finance Ramiro Galarza described his scenario to us. The GOE announces that it intends to buy back bonds. Rather than the dead silence which was the response of the market to similar offers under Yepez, allowing him to approach IESS and buy back, and then sell again, the bonds, Galarza believes all those wanting to sell will be clamoring to do so. As Ecuadorian law makes any official who carries out a transaction which "damages state interests" personally liable for the resulting financial loss, and as tradition is that officials face these charges upon leaving office, neither the Ministry nor IESS will be able to ignore private sellers willing to offer them a "deal" on GOE paper. Only by increasing interest rates on bonds, perhaps quite substantially, will the GOE be able to roll them over. This in stark contrast to last year's rollovers, where terms on the new debt issuances were quite favorable to the GOE. As some have noted, there is likely a price at which the GOE can succeed in rolling over the debt. However, this Minister came in promising lower interest rates, more loans, productive reactivation. If Galarza's scenario comes true, Correa's inability to deliver will be painfully obvious, and that could happen within the next few weeks. Time - Not On Their Side -------------- ¶26. (C) The GOE's amortizations do not come evenly over the year, of course. They will rise slowly from under $150 million in June to over $175 million in August, drop to less than $50 million in September, and then shoot up to about $200 million in each of the final three months of the year. Two weeks ago Mauricio Yepez told us that he was uncertain that the new minister, given his inexperience, would manage to finance the budget through August. We, however, expect that the real crunch will come in the last quarter. Mitigating Factor -------------- ¶27. (U) One factor which may mitigate concerns is the chronic inability of the GOE to expend resources efficiently. Funds provided to the National Development Bank last year for loans intended to generate growth and employment still sit unused in accounts at the Central Bank. The NDB could not get them out the door. The fear of retribution for "bad deals" as described above, locks much of the GOE bureaucracy in paralysis. It has been suggested by some analysts that the only way the GOE can get large sums out onto the street in an expeditious way is via salary increases. If Correa really wants to implement new "programs" it is unlikely he will be able to do so within the timeframe of the Palacio government. That said, he could make many people happy very fast by giving in to salary pressure. Correa's Convictions -------------- ¶28. (C) We have sketched Correa and his views in previous reporting (refs a and b),and fill in the picture somewhat above. However, we have also had the opportunity to discuss Correa with a variety of people who know him, some well, others less well, or who have met with him since he assumed his new position. These discussions tend to confirm the conclusions we have already drawn. Correa is intelligent, but allows his ideology to override his intelligence, a tendency which is transparent even in his academic writing. He is also extremely inflexible and unwilling to modify his views, even in the face of evidence. In his public discourse he openly insults his opponents and uses ad hominem attacks frequently. We wonder whether he will take suggestions and allow for open consideration on his staff. We have heard from various contacts a similar refrain: Correa will not be taught, he will have to learn for himself, and at what cost to Ecuador? Palacio's Premises -------------- ¶29. (C) Numerous contacts have suggested that Correa may be a "fast-burning minister," and may not last six months (many with hope in their voices). Other contacts, however, suggest that Palacio may also have an ideological preference for the radical statist policies Correa is promoting. The fundamental question is, how will Palacio react when presented by Correa with options which could lead to default? ¶30. (C) Banco de Guayaquil President Lasso, an acquaintance and former patient of cardiologist Palacio, noted that the doctor, though not a politician, had lifted his political philosophy from his communist father. Lasso did not think Palacio had drifted far from his father's views. He also said that Palacio was insufferably conceited and that he had changed cardiologists to avoid dealing with Palacio's ego. Together with Palacio's early statement about "political renegotiation," such comments are reason for concern. Off-Budget Shenanigans -------------- ¶31. (C) Of course, there are other things the GOE can do to damage the long-term prospects of the country. The Finance and Energy Ministers have been gleefully announcing that they will raid the IESS for $600 million to invest in Petroecuador. Several schemes have been floated, the most recent of which has IESS buying bonds from a trust fund backed by the company's future crude flows. Some commentators have noted that investing in a company which still has not published a balance sheet for 2004 and which has artfully avoided recent calls for an audit, may not be wise. Manuel Vivanco, one of the three board members of the IESS told us last week that the IESS board would never approve such a scheme, and that he believed pensioners would burn IESS to the ground if they did. An interesting battle may be brewing on the issue. So, What to Do? -------------- ¶32. (C) We continue to believe that it is important for the IFIs to maintain a hard line, disbursing only where conditionality is clearly met and responsible policies in place. We also believe that Palacio, and the rest of Ecuadorian society, need an education on the likely results of default for Ecuador. USG officials are not the best messengers to deliver this message, as we will be seen by Ecuadorians as interested parties, but we have many contacts and friends who can help to spread the alarm. Chacon