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