GOE RESPONDS TO INCREASING INFLATION

UNCLAS QUITO 000557 SENSITIVE SIPDIS TREASURY FOR MEWENS E.O. 12958: N/A TAGS: ECON EFIN EAGR PGOV EC SUBJECT: GOE RESPONDS TO INCREASING INFLATION REF: A: QUITO 267 ¶1. (SBU) Summary: Inflation has climbed dramatically in Ecuador in the past six months, largely due to natural disasters and international food and petroleum price increases, but also Ecuador's internal market structure. A Finance Ministry official detailed several GOE programs to fight inflation, including tax breaks and subsidies for farmers. However, a recent GOE price control and ban on exports of rice has created controversy among producers. End Summary. ¶2. (SBU) In Ecuador prices continue to rise, affecting every sector of the economy. The Ministry of Finance and the Central Bank of Ecuador (CB) initially projected inflation rates for 2008 of close to 3%. However, in May 2008 annual inflation hit 9.29%. Econcouns and Econ Specialist met with Mateo Villalba, Advisor to the Under Secretary of Macroeconomic Consistency in the Ministry of Finance, who provided an analysis of the various factors contributing to inflation in Ecuador and details on GOE programs to address them. INFLATIONARY PRESSURES -------------- ¶3. (SBU) According to Villalba, rising inflation in Ecuador is due to four factors: natural disasters, international food and petroleum price increases, growing domestic demand and nonresponsive local production, and the domestic market structure. ¶4. (SBU) Severe flooding that occurred in Ecuador in the spring and a volcanic eruption in 2007 (ref. a),as well as recent international price increases in food and raw materials, led to local price increases. Another pressure point has been rising international petroleum prices, which has a direct effect on the prices of agricultural inputs like fertilizers. To illustrate the rapid effect this has on consumer prices, Villalba said that a third of the final price of potatoes is attributable to inputs such as fertilizer. (Note: Ecuador has frozen the domestic price of fuel products since 2003, containing that source of inflationary pressure for the time being.) ¶5. (SBU) While the GOE has publicly blamed rising inflation on the shocks cited above, Villalba went on to explain additional domestic pressures. One that he mentioned is rising demand and inflexible supply. He noted that the government has increased the income of the poor by raising the minimum wage and the Human Development Bond (a targeted income transfer program). A high portion of the poors' income is immediately spent on food, so this led to a sharp increase in food demand. Conversely, food supply is inelastic due to the time required for crop planting and harvesting. In addition, small producers, who are responsible for an important share of Ecuador's agricultural production and therefore its prices, are highly sensitive to the cost of inputs, which have been rising. ¶6. (SBU) Villalba also said that because of high inflation in the 1990s, the Ecuadorian supply chain remains highly sensitive to price expectations. He noted that this is particularly pronounced for small-scale food retailers, who will rapidly raise prices of existing stocks in anticipation of price increases for future supplies. According to Villalba, 80% of Ecuadorians buy their food from small retailers, so this impact is substantial. (Note: food and non-alcoholic beverage prices contributed 59.4% to the latest increase in inflation.) PROGRAMS TO ADDRESS INFLATION -------------- ¶7. (U) According to Villalba, the GOE has been taking steps to address the different factors contributing to inflation, with a mix of policies including price controls, tariff cuts, subsidies, and export bans. The GOE agencies that have the lead in implementing anti-inflation policies are the Coordinating Ministry of Social Development and the Ministry of Agriculture, with financial support from the Ministry of Finance. ¶8. (SBU) In order to minimize the effects of natural disasters, the GOE is improving infrastructure in affected areas by rebuilding roads and bridges, and extending and refinancing agricultural producers' credits with the National Development Bank. On June 13, President Correa announced a USD 256 million GOE plan to support agricultural producers. He approved two decrees. One will partially subsidize small producers for the purchase of agricultural inputs; the other waives the value added tax (VAT) for agricultural inputs. Villalba noted that previously the GOE had attempted to support agriculture by directly providing subsidized inputs (fertilizer),but that program had not worked well, so this time around the GOE will allow agricultural producers to purchase inputs from their regular suppliers, and after presenting copies of their invoices they will receive the subsidy payment. Villalba allowed that the GOE was still working out the details of how subsidies would be implemented. ¶9. (SBU) There are three other fiscal measures that the GOE is contemplating in order to reduce costs for the agricultural sector in 2008 and 2009, Villalba explained. One measure is to reduce the tax on electricity consumption by the agricultural and commercial sectors by 10%, and another is to exclude companies that import agricultural inputs from income taxes so that they can sell these inputs at lower prices. The last measure is to exclude "unproductive land" from taxes (often, a portion of a farmer's land is "unproductive" either because it is being used for cattle grazing or because of insufficient funds for additional investment). ¶10. (SBU) Villalba commented that the GOE had considered further wage adjustments for the poor, but decided that this would increase domestic demand and put further upward pressure on prices. COMMENT: -------------- ¶11. (SBU) The GOE had previously used strong market interventions in an effort to slow inflation: price controls for milk, a ban on rice exports, direct provision of subsidized inputs. Those measures remain in place, but the latest round of measures show a greater willingness to work with the market using more moderate interventions. These newest measures seem to have been crafted in part by first undertaking a relatively thorough analysis of the underlying factors of inflation, as outlined by Villalba, something we have not necessarily seen in other GOE policy exercises. JEWELL