ECUADOR'S ECONOMY: DOING WELL FOR THE WRONG REASONS

UNCLAS SECTION 01 OF 04 QUITO 000289

SIPDIS

DEPT FOR WHA/AND
DEPT FOR WHA/PD LEBENS
DEPT PASS USTR FOR BENNETT HARMAN
DEPT PASS USAID LAC

E.O. 12985: N/A
TAGS: ECON ETRD ENRG EAID PGOV EC
SUBJECT: ECUADOR'S ECONOMY: DOING WELL FOR THE WRONG REASONS



1. Summary: Despite chronic political instability,
Ecuador's economy continues to hum along to the tune of high
oil prices, increased oil exports, dollarization (and the
resultant stability and low inflation),and responsible
fiscal policies. In 2004 the GOE paid down its
international debt and all economic indicators are looking
good. Prognostications for 2005 are also positive. The IMF
has issued a positive "assessment" letter on the GOE's
management of the economy and established an enhanced
surveillance program with the government, opening the door
to increased lending by international financial institutions
(from a low point in 2004). The GOE is planning further
attempts to enter financial markets and manage their
international debt. The cherry on top is the FTA. However,
much depends on the GOE's success keeping political poison
from infecting the economic sphere. And the cloud adorned
by all these silver linings is Ecuador's continuing
inability to carry out the crucial reforms needed for long-
term economic stability and growth. See paragraphs 14-22
for our plans to push forward U.S. economic and commercial
interests in the short, medium and long term. End Summary.

2004: The Year of Opportunity
--------------


2. A banking contact of ours recently concluded that, as a
result of dollarization and responsible economic management,
"Ecuador has seen the last of street mobs calling for the
overthrow of the President." We're not ready to go that
far, but our friend makes an important and oft-overlooked
point about the current situation here: despite all the
sound and fury of the repeated political crises, the
Gutierrez government has been one of the most economically
responsible governments of recent Ecuadorian history, and
the 2004 results, a combination of dumb luck and smart
policy, have been nothing short of spectacular. Economic
growth was about 6.5%, inflation dropped below 2%, and the
government paid back a net $400 million in international
debt, bringing its debt to GDP ratio to under 40% (down from
about 90% in 1999).

Dumb, and Not So Dumb, Luck
--------------


3. The price of oil is certainly the most obvious piece of
good luck Ecuador benefited from in 2004. Although
Ecuadorians have been disappointed to see the price for
Ecuador's heavy crude fall further behind that of lighter
crude with every price peak they reached, Ecuador has
benefited from a substantial windfall 1 from the increase of
prices over their 2003 level. The effect of the windfall
was particularly great as it coincided with an expansion of
over 50% in oil exports by private companies in the
aftermath of completion of the heavy crude pipeline (OCP for
its Spanish acronym) in late 2003. However, state-owned
Petroecuador struggled just to maintain oil production in
the short term, after a decade of decline.


4. With oil money sloshing into the country, the question
on many people's minds became how to use it. Public sector
workers went on strike; pensioners went on strike; teachers
went on strike; each seeking to share in the wealth.
Shielding themselves behind the fiscal responsibility law,
which limits increases in budgets and segregates oil
revenues from other revenues, dedicating them mostly to
payment of public debt, two responsible Ministers of Finance
held the line (mostly). The pressure eventually became too
intense for Mauricio Pozo, who resigned at mid-year to be
replaced by Mauricio Yepez, the former President of the
Central Bank. Both Mauricios applied a policy of under
executing the budget, and thus keeping it within the limits
set by the Fiscal Responsibility Law. The GOE ended 2004
with a very respectable primary fiscal surplus of 5.3% of
GDP.


5. The GOE's gamble on an FTA with the U.S. seemed to be
building upside and losing downside throughout the year. In
Fall 2003 it looked like Ecuador would be hard pressed to
enter the negotiations together with Peru and Colombia by
mid-year 2004. However, the GOE pulled out all the stops,
managed to resolve several commercial disputes, and not only
entered the negotiations together with the others, but
acquitted itself reasonably well in the negotiations
themselves.

The Weak Underbelly
--------------


6. Unfortunately, short-term high quality economic
management is not all Ecuador needs. The GOE fell off its
IMF program in February 2004, despite good fiscal policy, as
its political weakness had allowed it to show almost no
progress on structural reform during the previous year. No
real progress was made in 2004, either. An attempt to turn
over Petroecuador's "crown jewel" oil fields to private
management early in the year failed when the Attorney
General (reversing himself for the second time on the issue)
determined that the bidding round was illegal under current
Ecuadorian law. The GOE submitted legislation to Congress
twice to overcome this problem, and twice was forced to
withdraw it in the face of almost certain defeat. The GOE
also submitted legislation to carry out modest reforms in
the electric sector, but that legislation also went nowhere,
as did proposals to turn over management of state-owned
telecommunications companies to international management and
to carry out an external audit of Petroecuador.


7. In the fall, Yepez took another stab at convincing the
President to increase the price of (heavily subsidized)
cooking gas. (Pozo had tried the same in 2003, with the same
unsuccessful result.) Although the early response was
positive, the end of year political situation made this a
non-starter, again.


8. Despite an oft-repeated message from the U.S. on the
issue, Ecuador has made only limited progress on labor
reforms. The GOE did hire one child labor inspector for
each province, as required under its own law. It also
issued a watered-down decree regulating subcontracting.
However, real protection of the rights of workers in Ecuador
remains to be implemented.

2005: Another Year of Opportunity
--------------


9. The good news for 2005 is that all or most of the
opportunities Ecuador failed to take advantage of in 2004
are still available. There may even be a few new ones.


10. Two years of responsible fiscal policy, plus continued
high oil prices, may pay off this year. International
analysts suggest that the GOE may be over financed in 2005,
possibly by as much as $1 billion. This is the result of
expected increased disbursements by the international banks,
oil revenues, and likely new placements of international
debt. This would take pressure off the local market for GOE
debt, which was looking rather saturated in 2004. Yepez is
also planning $275 million in private debt placements, a
swap of the Global 12 bonds and a $400 million bond issuance
later in the year.


11. The IMF has grudgingly accepted the fact that GOE
fiscal policy remains responsible and that the country, for
the moment, has little need for the IMF's money. It agreed
in December to issue an assessment letter allowing funds
from other international financial institutions to flow. It
also established an enhanced surveillance mechanism with the
GOE, which amounts to quarterly reviews of GOE performance.
The Fund, like us, remains very concerned about the long
term given the lack of structural reform.


12. We expect the free trade agreement to be a major
political and economic issue in 2005. The conclusion of the
negotiations will lead to an intensification of the national
debate over the value of the agreement, and likely an
increased effort in the drive to collect signatures and
force a non-binding referendum on the agreement. The
general population seems uninspired by the FTA, but resigned
to its inevitability given Colombia's and Peru's likely
entry.


13. Yepez and his small band of reformers are making noise
about resurrecting the hydrocarbon law and the electric
sector reform, and have added to them a proposal for limited
social security reform. They suggest that the new
congressional majority the government wields may allow
passage. We are not optimistic. The new majority depends
on support from the MPD and the Socialists, neither of which
are likely to vote for any kind of economic reform, and the
bitterness between the government and the Social Christians
means that that party, which might be expected to support
some economic reforms, is not likely to vote for any GOE
proposal.

Our Plan
--------------


14. We are focusing our efforts on the short, middle, and
long range as follows:


15. Short Range: Crisis prevention and response. This
includes a focus on resolving the commercial disputes
involving U.S. companies and combating the extremely bad
policy initiatives which crop up on a regular basis (recent
examples include regulations which would have destroyed the
nascent credit bureau industry and legislation proposed by
the powerful Social Christian Party to fix interest rates
and otherwise hamstring the banking sector, which is still
recovering from the 1999-2000 banking crisis). We will also
focus GOE attention on the need to comply with international
labor standards to prevent Ecuador's exclusion from an
Andean-U.S. FTA. Our public affairs section, including its
Information Resource Center, is also involved in
congressional outreach, helping those interested in finding
sensible alternatives to bad proposals.


16. We continue to support Ecuador's participation in FTA
negotiations through key technical assistance, studies and
training. This assistance has been vital to the GOE's
successful participation in the negotiations. Moreover, we
have engaged in a broad ranging public awareness campaign
that seeks to inform the public about the benefits of the
FTA. The goal is not only to gather supporters, but also to
make people aware of the opportunities the agreement will
bring.


17. Medium Term: We look for targets of opportunity,
either institutions which can be reformed because committed
reformers are in leadership positions or policy reforms
which seem to have sponsors and support. For several years
now we have supported the Internal Revenue Service (SRI) to
improve tax policy and tax administration. Our support has
resulted in a dramatic increase in tax collection over the
last five years and the establishment of the SRI as one of
the few effective and well-respected institutions of the
GOE. We are currently focusing assistance on building SRI
capacity to collect from the largest taxpayers. USAID has
designed and is supporting a major reform of the Ministry of
Economy. Over 2-3 years the program will restructure the
day-to-day operations, personnel systems, accounting and the
information management system. A similar reform is underway
at the Superintendency of Banks, with USAID's assistance.
In addition we are supporting Yepez effort to develop and
implement a broad reduction in unnecessary personnel across
the public sector, which will help reduce salary
obligations, a huge burden on the budget and streamline
government services. We will do what we can to advise and
support Yepez in the reform projects he is pushing, and have
our own suggestions, as well. Though we are encouraging the
GOE to take steps immediately to better protect worker
rights through administrative means, substantive labor
reform is another goal more likely to be achieved over the
medium term.


18. Our public diplomacy strategy targets Ecuadorian
reformers, sending them on International Visitor programs to
expose them to the benefits of responsible policies.
Publications, CD-Roms and other material from our
Information Research Center, as well as the Embassy web
site, provide information opinion leaders need to bolster
their arguments. Speaker programs by US economic experts
and Embassy staff also are spreading the word. We will be
fully engaged in a very public campaign to help Ecuadorians
understand the benefits of the FTA for their country. We
hope to continue the AID-funded FTA public awareness
campaign that has already reached some 10,000 Ecuadorians.


19. Long Term: Despite our efforts and those of our allies
on economic reform in the medium term, we believe it likely
that the FTA will be the only significant economic reform of
the final two years of the Gutierrez administration. Our
long-term effort is centered on two key issues, making the
most of the FTA as an opportunity for reform and building
support among the youth for future reforms.


20. Ecuador will have to undertake a great deal of
institution building to comply with the terms of the FTA.
Our assistance will be critical to help the GOE adopt
standards, train its people, approve legislation and create
institutions. We can use FTA-mandated reforms in Customs
and intellectual property rights areas as a vehicle to clean
up the former and improve enforcement efforts on the latter.
In areas such as technical barriers to trade, competition
policy, labor regulation and environment control the GOE
will depend to a great extent on our assistance to implement
the agreement. Even where international financial
institutions are present to provide resources to address
some of these issues, USG assistance is essential to provide
tailored support, and to help address specific USG
interests.


21. Our public diplomacy efforts focus on increasing the
public's understanding of the real benefits reforms will
provide in accomplishing Ecuador's long term social and
economic development goals, particularly among the young
leaders of today who will shape Ecuador's future. We are
encouraging qualified candidates to apply for Fulbright
scholarships to study in the United States and supporting
the English teaching programs that give them the edge they
need to compete internationally. We are focusing our press
and outreach programming on such issues as transparency in
government, fighting corruption and the need for greater
civic participation in order to encourage the successor
generation to carry on fight for continued reforms.

Resource Constraints
--------------


22. We are concerned that reductions in Economic Support
Funds for Ecuador, as well as Nethercutt amendment and other
sanctions may significantly affect our ability to help our
allies in the GOE move economic reforms forward. It would
be particularly unfortunate if we were unable to help them
take advantage of the FTA to spur reforms along, and would
directly damage both our commercial and our strategic
interests in Ecuador.

KENNEY

_______________________________
1How much