ECUADOR'S CENTRAL BANK TO USE INTERNATIONAL RESERVES TO

UNCLAS QUITO 000816 SENSITIVE SIPDIS E.O. 12958: N/A TAGS: EFIN ECON EC SUBJECT: ECUADOR'S CENTRAL BANK TO USE INTERNATIONAL RESERVES TO SUPPORT DOMESTIC INVESTMENT -------------- SUMMARY -------------- ¶1. (SBU) In an attempt to boost internal demand, President Correa announced August 27 a plan to repatriate US$1.6 billion in international reserves to fund domestic investments. During a September 1 meeting with EconOffs, the General Manager of Ecuador's Central Bank (BCE),Karina Saenz, confirmed that the BCE will channel the reserves via the GoE's National Finance Corporation (CFN). The CFN will then use the funds to issue medium-term loans to the private and public sectors. Saenz subsequently told local press that the BCE plans to complete the repatriation of reserves by year's end. However, the plan may require changes to the BCE's legal framework. This sharp reduction in international reserves could increase concerns about the soundness of Ecuador's financial system and overall economy. End Summary. -------------- -------------- BCE to repatriate US$1.6 billion international reserves -------------- -------------- ¶2. (SBU) On August 7, 2009, the BCE announced it was issuing a regulation that would require $300 million of the country's international reserves to be invested domestically through the CFN, a second-tier, government-owned financial institution that provides loans to state-owned and private commercial entities via banks (and also administers several public trusts created to finance microcredit programs). However, during an August 27 televised broadcast, President Correa super-sized the initiative, announcing the GOE's intention to repatriate a total of $1.6 billion in international reserves to fund domestic investments. ¶3. (SBU) One existing obstacle to this initiative is that current Ecuadorian law requires that international reserves be invested abroad. Local law also prohibits the BCE from granting credits to other entities, such as the CFN. Following the August 7 announcement, BCE President, Carlos Vallejo, suggested to the press that the BCE could get around this impediment by having the Ecuadorian Social Security Institute (IESS) use its deposits at the BCE to purchase BCE securities. This action would reduce IESS deposits and the corresponding international reserves on the assets side of the BCE's balance sheet. The BCE would then use the proceeds of the sale to capitalize the CFN. It appears that the BCE has not yet finalized this mechanism and it is still possible that changes to the BCE's legal framework may be required. ¶4. (SBU) During a September 1 meeting with EconOffs, BCE General Manager Karina Saenz said that the BCE's financial holdings abroad currently total around US$ 5 billion (this includes approximately US$ 4 billion in gross international reserves and US$ 1 billion of Central Bank foreign assets.) She confirmed that the BCE will invest the US$ 1.6 billion of reserves - which she referred to as "excess liquidity" -- in domestic investments in infrastructure and other projects, via the CFN and as defined by the Secretary of National Planning (SENPLADES). ¶5. (SBU) Saenz explained that the CFN will use these funds to disburse five to eight-year loans to private and public sector entities (via mostly private sector banks operating in Ecuador). She also confirmed that this US$1.6 billion includes the US$ 300 million initially announced by the BCE's President in early August. During a subsequent press interview, Saenz stated that the BCE will repatriate the US$ 1.6 billion by December 31. Saenz told Econoffs that she is confident the BCE will find a mechanism to repatriate the funds and invest them in CFN that is legal. One option the BCE is exploring is to sell BCE securities to the market (essentially to the IESS and banks),using the proceeds to buy CFN securities. (Comment: However, this option anticipates market demand for BCE financial instruments that may not exist.) -------------- Concerns about Inadequate Reserve Levels -------------- ¶6. (SBU) It is not clear that the BCE currently has sufficient reserves to cover its liabilities, as spelled out in its Charter: currency in circulation, banks' legal reserves (deposited at the BCE),and public sector deposits at the BCE. The repatriation of $1.6 billion in reserves would require a dramatic drawdown of the Central Bank's public sector deposits. However, as of August 21 (the latest data available),GoE deposits comprised only $1.2 billion of the total $4.1 billion in international reserves. A further $1.5 billion in reserves represented the deposits of other public entities (including the IESS) and local governments. ¶7. (SBU) Should the GoE remove $1.6 billion from all available public sector deposits, the remaining level of international reserves would without a doubt be insufficient to cover the BCE's total liabilities. Therefore, the BCE may decide to use some percentage of its own cash holdings of over $1 billion (including the BCE employees' pension fund),which are not counted as international reserves and are not subject to the legal constraint on investing domestically. -------------- -------------- Comment: Increased Vulnerability to Financial Instability -------------- -------------- ¶8. (SBU) Comment: BCE General Manager Saenz confirms private analyst's speculation that the plan to invest international reserves domestically reflects Ecuadoran authorities' belief that the country's lack of financing is constraining internal demand and, therefore, economic growth. However, there are numerous hurdles, and the private sector is right to criticize the initiative on several fronts. -- First, it is not clear that the BCE will be able to raise financing in a way (such as through the sale of BCE securities) that allows it to skirt existing prohibitions on the investment of reserves domestically. Private sector banks are already upset at GoE and BCE over-regulation, interest rate controls, and recent decrees requiring them to repatriate a percentage of their own overseas holdings, and are reluctant to buy additional GoE or BCE bonds of their own volition. Furthermore, the IESS's President, Carlos Gonzalez, has commented publicly that the IESS does not have the capability to provide much additional financing, given that it bought $1.2 billion in GoE bonds in December 2008 and has already invested $400 million in CFN. -- Second, the dramatic reduction in international reserves could increase concerns about the GoE's financial stability. Not only would the BCE's investment in CFN be much less liquid than are their current investments in international assets (i.e., U.S. Treasuries),but they also bring a much higher credit risk. -- If the BCE goes through with this initiative, we expect the general perception will be that the BCE is less capable of responding adequately to a run on the banks, leaving the economy more vulnerable to external shocks. HODGES