1. We want to thank staff for the set of well-written papers and for their candid and thorough analysis on the Ecuadorian economy. Since Ecuador took the decision to officially dollarize its economy three years ago, the main economic indicators have stabilized, economic activity has recovered, and expectations have improved. Real GDP grew 2.8 percent in 2000 after a 6.3 percent decline in 1999. In 2001, growth remained strong at 5.1 percent, but slowed in 2002 to 3.0 percent due to fiscal slippages that affected confidence, a fall in oil production, and slower global economic activity. Notwithstanding, in both years, the rate of growth was the highest in the Region. Fiscal discipline weakened in 2002 with large increases in the wage bill and expenditures in goods and services. Unemployment has been reduced from 14.4 percent in 1999 to 8.7 percent at end-2002. Inflation has come down sharply. The 12-month rate of inflation fell from 91 percent at end-2000 to 9.4 percent at end-2002, but remains still too high for a dollarized economy. However, using the data reported by the staff to calculate US dollar inflation since end of 1998, the consumer price index would still be below that of 1998 by end-2002.

2. The non-financial public sector (NFPS) registered a primary fiscal balance of 7.7 percent of GDP in 2000 helped by high international oil prices, improved tax collections, and the fact that the 2000 budget was approved by Congress in September 1999 at a much lower exchange rate than the exchange rate used for dollarization. In 2001 and 2002, the primary fiscal balances were 4.3 and 4.5 percent of GDP, respectively, due to the recovery of government spending and the drop in oil prices. The overall fiscal result was a surplus of 1.0 percent of GDP in 2000, but turned negative in 2001 registering a deficit of-0.5 percent of GDP. In 2002, the overall fiscal balance was again positive registering a 1.0 percent of GDP surplus. However, despite an overall NFPS surplus, the central government’s own cash position in third and fourth quarters of 2002 was very tight. Extensive constitutional earmarking resulting in automatic higher expenditures that, together with the sharp increases in the wage bill and in goods and services expenditures, forced the Treasury to end 2002 with over US$700 million in domestic and external arrears.

3. After registering a surplus of 6.3 percent of GDP in 2000, the external current account recorded a deficit of 5.0 percent of GDP at end-2002. The decline mainly reflected strong import growth associated with the recovery of economic activity and with the imports for the construction of the new oil pipeline (OCP). Also, the appreciation (after the sharp depreciation of 1999 and 2000) of the real effective exchange rate contributed to the surge in imports. Government deposits, a better measure of public sector liquidity than net international reserves in a dollarized economy, were 5.2 percent of GDP at end-2002, enough to cover more than a year of interest payments, which amounted to 3.46 percent of GDP. Foreign Direct Investment, driven mainly by the oil sector, was 5.1 percent of GDP at end-2002. The public debt-to-GDP ratio declined from 102 percent at end-1999 to 60 percent at end-2002. The external debt-to-GDP ratio declined from 82.8 percent in 1999 to 46.9 percent in 2002, reflecting mainly the 40 percent reduction of external debt agreed with bondholders, the appreciation of the real effective exchange rate and the rapid GDP growth of the last three years. The high ratio in 1999 also reflected the high depreciation of the real exchange rate.

4. The private banking system has recovered after being affected by the currency and banking crises. The liquidation of 16 closed banks under the administration of the Deposit Insurance Agency (AGD), and the resolution of the government owned Filanbanco, once the largest bank in the system, have been more turbulent than anticipated. Legal difficulties and political pressures have delayed the collection of US$1.6 billion in defaulted loans previously granted by the closed banks to big private debtors. These banks still have blocked deposits. About US$275 million deposits are unpaid in early 2003. Banco del Pacifico, the private bank in the hands of the Central Bank, which has been under private management since end-2001, recorded profits at end-2002 and has been consistently ranked among the four largest banks in the system. Private bank deposits increased by 30 percent over 2001-2002. The foreign net position was positive at end-2002 and enough to cover 14.5 percent of the banking system total liabilities, 46 percent of demand deposits, and up to 30-day maturity time deposits.

5. The banking system soundness indicators have improved. The share of non-performing loans to total loans declined from 42.3 percent in 1999 to 6 percent in 2002. The private bank’s profit margins have been high in the last two years. Average deposits rates have remained around 5 percent and average lending rates were close to 14 percent at end-2002. The high interest spread reflects the high cost of maintaining a liquidity cushion deposited abroad, efforts to restore profitability and the continued high EMBI spread on sovereign bonds that serves as a benchmark to determine domestic interest rates. Furthermore, it reflects a change in the composition of loan portfolios, which have shifted from corporate lending to consumer lending. In this scenario, private external corporate debt has increased from 15.2 percent of GDP at end-1999 to 20.0 percent of GDP at end-2002. Overall, monetary aggregates expanded rapidly during 2001-2002 as improved stability and real economic growth led to re-intermediation of the financial system. Despite improvements in its financial soundness, the financial system remains vulnerable in the absence of a lender of last resort. However, this vulnerability has to be counterweighted with the reduction of a persistent moral hazard risk.

6. In December 2002, one month before taking office, the newly elected authorities began substantive negotiations with Fund staff for a Stand-By Arrangement. After taking office in January 15,2003, the government implemented measures to tighten the fiscal position and announced a very ambitious program of structural reforms to be submitted to Congress during 2003. On January 19, prices for gasoline and other fuels were increased by an average of 25 percent. Together with improved operational cost control in the oil estate company and at the retail level, these decisions are expected to yield 1.5 percent of GDP equivalent to US$400 million. Also, some import tariff concessions that were granted in late 2002 were reversed, expecting to yield 0.1 percent of GDP, equivalent to US$30 million.

7. On February 10, during the visit of President Gutierrez to Washington, the Minister of Finance and the President of the Central Bank requested on behalf of the government of Ecuador, a 13-month Stand-By Arrangement in the amount of SDR 151 million equivalent to 46 percent of quota.

8. According to the fiscal program, the cooking gas subsidy will be eliminated before end-June, generating a gross yield of US$75 million or 0.3 percent of GDP. As part of the structural reforms, the government will send to Congress a law to unify the public sector wages that will widen the base for social security contributions. This is expected to yield about US$20 million, equivalent to 0.1 percent of GDP for 2002, with a much higher projection for 2003. On January 22, in order to control expenditures, the government issued an Austerity Decree that included a freeze on central government wages for regular employees and cut spending on goods and services. To compensate the poor for some of the above revenue measures, the government raised the cash assistance program (bono solidario), effective January 2003, from US$11.50 to US$15.0 per eligible person per month, while welfare assistance for the elderly poor was increased by US$5.0 per person. More than 1.4 million family heads are covered by this program.

9. In January, the new government sent to Congress the 2003-budget proposal consistent with the program. The budget includes a freeze on wages and is based on an oil price assumption of US$18 dollars per barrel for the Ecuador mix that is on average US$3 to US$4 dollars less than the WTI price. The government is committed to cut expenditures if oil revenues fall below those envisaged in the program. The 2003 fiscal program projects to strengthen the primary surplus from 4.5 percent of GDP in 2002 to 5¼ percent. This target is consistent with an overall surplus of 2.0 percent of GDP higher than the 1.0 percent registered in 2002.

10. In September 2002, Congress approved the Fiscal Responsibility and Transparency Law (FRTL), and in January 2003 the new government issued regulations for its implementation. This law improves transparency of the budgetary process, and has set up important macro fiscal rules to manage the fiscal policy with a long-term fiscal approach. Basically, it establishes rules to limit the growth in the primary budgetary expenditures to 3.5 percent in real terms annually, to reduce the non-oil public sector deficit in 0.2 of GDP per year and to improve the public debt/GDP ratio in 16 percentage points in the next four years. It also creates an oil stabilization fund, which allows the government to save 90 percent of the fiscal revenues coming from the new oil pipeline. Twenty percent of the revenue inflows from the new pipeline will go to a fund for oil price stabilization and emergencies, and 70 percent will be allocated for debt buy-backs aiming to reduce the ratio of public debt to GDP to a maximum of 40 percent, not to be exceeded once this objective is reached. The other 10 percent will be spent in social programs and subject to the fiscal rule of 3.5 percent.

11. The external current account deficit is projected at 5.3 percent of GDP in 2003, higher than the 5.0 percent registered at end-2002 due basically to a conservative oil price for the projections (US$18 per barrel). A one dollar increase in the oil price represents more than US$90 million in a year basis. The capital account would remain strong, reflecting continued FDI inflows, dominated by the oil industry, which needs to invest in wells to fill the new pipeline.

12. The structural fiscal reforms agenda is very ambitious and aims to build institutions consistent with dollarization. The authorities have sent to Congress, on a fast track basis, a Custom Reform Law to overhaul the customs administration and to bring it under the umbrella of the Internal Revenue Service (SRI). In the second week of March, Congress amended the proposal to merge customs with the SRI administration. According to the Ecuadorian Constitution, the President has the legal power to veto what the Congress has approved and to re-write new provisions. Before April 30, the government will submit a public sector Wage Unification and Civil Service Reform, which aims at achieving a lower nominal wage bill in 2004 by reducing the number of public sector employees. Under the wage unification, the various components of remuneration will be brought together in one salary statement, which then will be the new basis for the assessment of social security contributions that will yield about US$20 million in 2003.

13. Before end-August 2003, the government will submit to Congress a comprehensive tax reform bill intended to allow for a more efficient allocation of public spending and to expand the tax base. One of the main features of the proposal is to eliminate all revenues earmarked that are not mandated in the Constitutition. The government will seek congressional approval of this reform by end-November 2003.

14. The authorities are committed to develop and implement a set of policies to maintain a sound financial system. These include the strengthening of banking supervision, reforming the liquidity support system, and improving mechanisms for the recovery of nonperforming loans. The Association of Private Banks (ABPE) has been analyzing with the authorities the possibility to pool their liquidity to structure a new liquidity facility. This new fund could cover 35-45 percent of total deposits, giving it an ample margin to act as lender of last resort and to serve as a guarantor of the payment system. The authorities are committed to liquidate Filanbanco and eight of the closed banks in the hands of the AGD. Parallel to the liquidations of the closed banks, the private sector debt portfolios of the banks that were already restructured will be auctioned off. Banco del Pacifico will be brought to the point of sale to the private sector by end-July 2003. The program envisages US$2,212 million in total financing, and US$574 million in exceptional financing. The WB, IDB and CAF will contribute with US$330 million, the IMF with US$160 million, with the remaining US$84 million coming from expected debt relief from Paris Club creditors on a rescheduling of arrears and current maturities.

15. According to the stress tests of the public debt sustainability analysis conducted by staff, which takes into consideration the operation of the new oil pipeline (OCP) and the implementation of the FRTL, the potential for debt reduction is robust even if the economy is affected by strong shocks. The public sector debt to GDP would come down to 37.2 in 2005 and 25.7 percent in 2007. The NFPS overall fiscal surplus would increase from 2.0 percent in 2003 to 4.0 percent in 2005. In this scenario, inflation would fall to international levels by 2005 and GDP would grow 6 percent in 2004 and 6.5 percent in 2005, with growth remaining strong thereafter. The external current account deficits that have been around 5 percent of GDP in the last two years would also decline in the medium term, backed by the boost in oil exports from the new pipeline.

16. We ask the members of the Executive Board to support the program, and approve the exchange restriction in the form of blocked deposits in the closed banks until end-December 2003 and the extension of repurchase expectations to an obligations basis during the period of the Stand-By Arrangement. On behalf of our Ecuadorian authorities, we would like to thank staff, Management, and the Executive Board for the support given to Ecuador. Our Ecuadorian authorities have ownership of the economic program, and are fully committed to its implementation and, if necessary, to take the appropriate decisions to secure fiscal and external sustainability in the medium term.