Trying to handle the double shock

Ecuador seems overwhelmed by the covid-19 pandemic. Despite early containment measures, the country’s number of covid-19 deaths per capita is by far the worst in Latin America. Both the health care system and the government appear unable to handle the health crisis. Moreover, the sharp drop in oil prices and lower external demand deal another blow to the economy. Ever since the first oil price drop in mid-2014, the country has experienced rather sluggish economic growth of around 0.5% on average annually (see graph 1). However, the dual oil price and covid-19 shock is expected to push the economy into a severe economic recession of 6.7% this year, the sharpest decline in South America. Next year, the IMF expects only a relatively mild recovery of 4.1% under the assumption that the covid-19 pandemic will be under control. Looking forward, the picture remains grim: the lower oil prices will dampen real GDP growth in the medium term and a return to the 2019 GDP level is not expected anytime soon.

Political unrest in the cards

The double shock comes at a time when the political capital of the incumbent President Moreno was already under pressure. Political stability has been strained ever since President Moreno started cracking down on corruption of the previous administration of left-wing populist Rafael Correa (2006-2016). The alienation with the previous administration leads to polarisation in the Andean country. Furthermore, fiscal consolidation in combination with low economic growth fuelled dissatisfaction, especially in the past year, which translated into violent protests in late 2019. The economic and health crises are further stoking unrest. Recently, in the midst of the covid-19 crisis people took to the streets to ventilate their discontent. Therefore, as soon as the covid-19 virus wanes in the country, protests are very likely, especially in the run-up to the 2021 presidential elections. 

Current account deficit financed by foreign exchange reserves, China and multilaterals

Ecuador has suffered from relatively low oil prices since 2014 as the oil sector represents about 10% of total GDP and more than 30% of current account receipts (in 2019). Since 2010, the current account has shown a small deficit of about 1% of GDP on average (notwithstanding a small surplus in 2016). The recent drop in oil prices is forecasted to widen Ecuador’s current account deficit to roughly 5% of GDP. With the low oil price forecasts and Ecuadorian competitiveness suffering from the strength of the US dollar (as the country has been fully dollarised since 2000), current account deficits are expected to only narrow gradually in the coming years. What is more, portfolio investments (also known as ‘hot money’) have been the most important source of financing for the current account deficit and might decrease this year amid the sharp deterioration of global financial conditions. Another, more stable, source of financing (foreign direct investments or FDI) has been more volatile in the past years. President Moreno has been trying to boost FDI. However, policy choices under the Correa administration eroded trust. As there is currently no access at all to international capital markets, foreign exchange reserves are projected to finance a significant part of the shortfall as well as financing from multilaterals, including an IMF RFI. That being said, more financing should still be found which represents a challenge also in the medium term as FDI are likely to remain low and access to financial markets fragile.

Despite Ecuador’s economy being fully dollarised, foreign exchange reserves are at a worrying level

It should be noted that since 2017 foreign exchange reserves have been below 1 month of import cover, a very low level. Foreign exchange reserves are in general a less important indicator for a fully dollarised economy. Nevertheless, liquidity buffers in foreign currency may still be needed to fund the domestic financial sector or the public sector in cases of unexpected fluctuations. In March this year, foreign exchange reserves stood at 0.4 months of import cover but they’re likely to have fallen since then as demand for cash increased in the wake of the covid-19 crisis and public-sector external debt service has been paid. The IMF expects foreign exchange reserves to rise in the coming years but if external financing doesn’t come forward, there’s a risk of depletion of the foreign exchange reserves. In the Ecuadorian context, this would imply a liquidity crunch, which could in turn inspire the government to impose import or capital controls or default on its debts.

Increased risk of sovereign-debt restructuring

Even if figures are not worrying yet, public finances are weak. The numbers deteriorated after an oil price shock in mid-2014 and the earthquake in 2016, and have not recovered since then despite an IMF programme in 2019 (which was recently cancelled). The recent oil price slump (oil represented more than 20% of government revenues in 2019) in combination with higher expenses to tackle the covid-19 virus and the large recession have obviously worsened the picture. The fiscal deficit is expected to rise to 7.5% of GDP in 2020, and to come down only gradually in the coming years under huge fiscal consolidation efforts. Indeed, the government is taking far-reaching measures including scrapping seven state-owned companies, liquidating the national flag carrier and closing embassies around the world. Nevertheless, public debt is projected to rise to almost 65% of GDP this year and to continue to swell thereafter, to peak in 2023 at roughly 70% of GDP. Hence, public debt more than tripled since 2013 when it stood at 20% of GDP. Whereas on paper these ratios might seem manageable, Ecuador reported to be unable to pay its external debt service. As a fully dollarised economy, the low level of foreign exchange reserves in combination with the large fiscal and current account deficits and the lack of access to financial markets, explains the issues of the government to pay its external debt service. Bondholders granted a delay of interest payments of USD 800 m through mid-August to handle the current covid-19 crisis. Though the mutual deal is mitigating the risk of a debt default in the coming weeks, a debt-restructuring agreement, both with bilateral and private creditors, will be necessary in the coming months based on the large external financing needs for 2020 and beyond. Even under favourable assumptions (including the prompt restoration of normal market access and sufficient financing from multilateral and official bilateral sources), public external debt service is expected to consume on average one fifth of public revenues and one third of current account receipts per year in the coming years. That is significantly higher than the average in the past five years. On top of that, many downside risks loom: lower-than-expected real GDP growth, higher bond spreads, lower oil prices, materialisation of contingent liabilities and failure to commit to fiscal consolidation (e.g. under a possible new president after the 2021 elections and increased social pressure).

External debt at highest level in two decades

The recession and expected external financing will likely cause external debt to jump from 44% of GDP in 2019 to almost 56% of GDP in 2020. Around 90% of external debt is attributed to the public sector. Although external debt ratios are at a rather elevated but not alarming level, they’re at the highest level in two decades. Also in the medium term, external debt is projected to increase due to rising public external debt, though at a more gradual pace. External debt service is a huge concern. It has risen quickly since 2014, to dangerously high levels of about 63% of current account revenues in 2020. External debt service mainly exist of amortisation payments with private and public amortisations being roughly equal. External debt service ratios are predicted to come down thanks to a recovery in current account receipts, to around 50% of current account receipts in the coming years – still a very high level. Rising interest rates as of 2023 in combination with higher private amortisations as of 2021 and sovereign bonds maturing every year as of 2022 mainly explain the high levels of external debt service in the medium term.

ST political risk rating downgraded while MLT political risk rating remains stable for now

The large current account deficit in 2020, in combination with the low and falling foreign exchange reserves and rising short-term external debt, led Credendo to downgrade Ecuador’s short-term political risk rating by two notches to category 6/7. The medium- to long-term political risk rating remains stable in category 6/7 for now. Despite the clear deterioration of the macroeconomic fundamentals of the country, the bilateral and multilateral support for the country in combination with the full dollarisation mitigates the risks.

Analyst: Jolyn Debuysscher – J.Debuysscher@credendo.com