Ecuador: 2005 Article IV Consultation—Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Ecuador
Author: International Monetary Fund
Publication Date:
10 Mar 2006
eISBN:
9781451811827
Language:
English
Keywords:
ISCR; CR; CPI inflation rate; deficit; minister; government; private sector; exchange rate; banking system; fiscal policy; heavy crude oil; Oil prices; Global
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This 2005 Article IV Consultation highlights that despite a difficult political environment, economic growth in Ecuador is estimated to have exceeded 3 percent in 2005, with the non-oil sector expanding by 3½ percent. The strong growth in the oil sector that followed the completion of the new oil pipeline in 2003 has tapered off, but high oil prices have helped bolster confidence and underpin domestic demand. The external current account deficit is estimated to have remained unchanged at about 1 percent of GDP.

Abstract

This 2005 Article IV Consultation highlights that despite a difficult political environment, economic growth in Ecuador is estimated to have exceeded 3 percent in 2005, with the non-oil sector expanding by 3½ percent. The strong growth in the oil sector that followed the completion of the new oil pipeline in 2003 has tapered off, but high oil prices have helped bolster confidence and underpin domestic demand. The external current account deficit is estimated to have remained unchanged at about 1 percent of GDP.

I. Background

A. Political Context

1. Political conditions have been turbulent in 2005. Congress dismissed President Gutierrez in April. His successor, President Palacio, became Ecuador’s sixth president in the last 8 years.

  • For much of his time in office, President Palacio has been locked in a dispute with Congress over his desire to set up a constituent assembly that would have powers to design and implement wide-ranging political reforms.

  • After initially encouraging expectations for a broad expansion in government spending, the new government has shown a greater concern for fiscal discipline and for advancing much needed structural reforms, while continuing its strong emphasis on addressing the country’s social needs.

  • However, because of the government’s weak political base—it has no party affiliation or representation in Congress—and the population’s increasing focus on the October 2006 presidential and congressional elections, it has had difficulties in withstanding pressures for more public spending and in resisting inappropriate policy initiatives from powerful interest groups and local governments.

B. Recent Economic Developments

2. The economy has been largely resilient to the difficult political environment and, aided by high international oil prices, macroeconomic performance in 2005 was generally positive.

  • Overall GDP growth is estimated to have exceeded 3 percent, with the non-oil sector expanding by 3½ percent (Figure 1). The strong growth in the oil sector that followed the completion of a new oil pipeline in 2003 has tapered off, but high oil prices have helped bolster confidence and underpin domestic demand.

  • Employment growth has remained sluggish, however, and the unemployment rate, which averaged 10.7 percent, was little changed from 2004.

  • Driven mainly by strong growth in bank credit and public spending, 12-month CPI inflation rose from less than 2 percent in June 2005 to 4 percent at the end of the year despite frozen domestic fuel prices (Figure 2).

  • The external current account deficit is estimated to have remained unchanged at about 1 percent of GDP, reflecting rapid import growth which offset strong increases in oil and non-oil exports led by shrimp and metal products (Figure 3). While oil sector FDI inflows increased, non-oil FDI remained low, at less than 1 percent of GDP.

Figure 1.
Figure 1.

Ecuador: Real Sector

Citation: IMF Staff Country Reports 2006, 098; 10.5089/9781451811827.002.A001

Sources: Central Bank of Ecuador; and Fund staff estimates.1/ 2005 observation is for the first half.
Figure 2.
Figure 2.

Ecuador: Prices

Citation: IMF Staff Country Reports 2006, 098; 10.5089/9781451811827.002.A001

Sources: Central Bank of Ecuador; and Fund staff estimates.1/ Staff projection for 2005.2/ Fiscal spending is NFPS current primary spending plus returned social security contributions.
Figure 3.
Figure 3.

Ecuador: External Sector Indicators

Citation: IMF Staff Country Reports 2006, 098; 10.5089/9781451811827.002.A001

Sources: Central Bank of Ecuador; and Fund staff estimates1/ 2005 observation is for the year ending in June.2/ 2005 observation is for the year ending in September.3/ 2005 observation is January-September average.

3. Investor confidence has improved.

  • Banking system credit and deposits grew strongly in 2005, while liquidity remained at comfortable levels and other stability indicators continued to improve (Figure 4). Moreover, there was no evidence of spillover effects on deposits or on interest rates from the political turbulence. However, bank intermediation is still well below pre-crisis levels and deposits are overwhelmingly at short maturities.

  • The authorities successfully regained access to international capital markets with a US$650 million bond issue in December 2005. The 10-year bullet bond, with a yield of 10.75 percent (95 basis points below that of the existing 2012 global bond) was greatly oversubscribed. Nevertheless, the EMBI spread, although having declined substantially in the past year, remains the widest among Latin American countries.

Figure 4.
Figure 4.

Ecuador: Monetary Sector Indicators 1/

Citation: IMF Staff Country Reports 2006, 098; 10.5089/9781451811827.002.A001

Sources: Central Bank of Ecuador; Bank Superintendence and Fund staff estimates.1/ Yearly data for 2005 based on November figures.2/ Short term deposits include sight and term deposits with maturities under 91 days.3/ Ecuador average refers to 84-91 day loans. El Salvador average refers to short-term loans. Ecuador prime is the corporate rate for loans with maturities below 30 days.

4. Although public debt ratios continued to fall and liquidity problems eased in 2005, the underlying fiscal stance has weakened (Figure 5). In recent years, non-financial public sector (NFPS) primary surpluses have been maintained consistently above 4 percent of GDP, reflecting mainly high oil revenues, which have helped reduce public debt from over 90 percent of GDP in 2000 to 43 percent of GDP in 2005. However, the non-oil deficit is projected to have increased to 5 percent of GDP in 2005, driven by the growing cost of fuel subsidies (owing to fixed domestic prices) and the continued rapid expansion of recurrent spending, especially in wages and pensions.

Figure 5.
Figure 5.

Ecuador: Fiscal Indicators 1/

Citation: IMF Staff Country Reports 2006, 098; 10.5089/9781451811827.002.A001

Sources: Ministry of Finance and staff; and Fund staff estimates.1/ Staff projections for 2005 and 2006.
uA01fig01

Current Spending and Non-oil Balance, 2004-05

Cumulative changes since 2003 in percent of oil windfall

Citation: IMF Staff Country Reports 2006, 098; 10.5089/9781451811827.002.A001

5. The authorities aim to restrain recurrent spending in their 2006 fiscal program to make room for larger capital and social spending while maintaining an overall primary surplus above 4¾ percent of GDP. Their budget proposal envisages growth in wages and pensions of 4 percent, compared with 15 percent a year during 2002–05. However, capital spending is projected to rise by some 40 percent, in line with the authorities’ priority of addressing the country’s outstanding social and infrastructure needs. Under current WEO oil price projections, the authorities’ program would be consistent with an increase in the NFPS surplus to 4.8 percent of GDP from 4.2 percent in 2005 and a decline in public debt to 40 percent of GDP. However, the non-oil deficit would remain unchanged, reflecting a further substantial increase in the cost of fuel subsidies. The fiscal program for 2006, which also includes significant resources earmarked for liability management operations, appears to be adequately funded, reflecting the recent bond issue and approved disbursements in January 2006 from the Latin American Reserve Fund (FLAR). The authorities also expect to receive US$400 million in budget support financing from the multilaterals, half of which appears to be well in train.

6. There has been little progress in implementing structural reforms to enhance the prospects for long-run growth or address key economic vulnerabilities as discussed in the 2004 Article IV consultation. Rather, many of the measures that have been implemented in the last year weakened the macroeconomic policy framework.

  • Reforms stalled in Congress. The Gutierrez government made three unsuccessful attempts to pass oil sector reforms in Congress, and had two electricity reform proposals rejected. Congress also rejected (without debating) an omnibus bill containing proposals for reforms in the oil and electricity sectors, fiscal area, pension system, labor market, and financial system, many of which were in line with recommendations of the 2004 Article IV consultation. In December 2005, Congress again rejected an electricity reform bill that aimed to settle intra-sector debts and introduce incentives for greater private participation in electricity generation.

  • The overall framework for fiscal policy has weakened. In June, Congress approved a reform to the fiscal responsibility law (FRL)—sponsored by the new government—that eliminated the FEIREP oil fund, removing capital spending from the ceiling on primary expenditure growth, and increasing the earmarking of oil revenues (Box 1).

  • The actuarial deficit of the pension system has increased. Congress approved a bill which returns the accumulated assets of the Social Security Institute’s (IESS) reserve fund to employees every three years.1 In addition to the impact on the actuarial deficit, the reform potentially complicates liquidity management for the central government since about half of the IESS’s portfolio is invested in government paper.

  • The tax base has been eroded. A government-supported law granting generous tax incentives to foster investment in various sectors was approved by Congress.2 The law’s effectiveness to encourage investment is doubtful, but it would weaken the tax base and complicate tax administration.

  • Some headway was achieved in financial sector reforms. The Superintendency of Banks tightened up regulations governing capital and liquidity in line with the 2004 FSAP recommendations. Congress approved new anti-money laundering legislation and passed a law to strengthen the operation of credit bureaus. However, a new banking law recently sent to Congress by opposition parties raises serious concerns (Box 2).

Modifications to the Fiscal Responsibility Law

The authorities’ decision to change the Fiscal Responsibility Law (FRL) was based on a desire to increase resources for capital and social spending. Even though compliance with the original law was far from perfect, the June 2005 reform of the FRL weakened the overall framework for promoting fiscal discipline.

  • The reform removed capital spending from the 3.5 percent cap on annual real increases in central government primary expenditure.

  • It retains the requirement that the non-oil fiscal deficit decline by 0.2 percent of GDP per year, but this provision was violated in both 2004 and 2005.

  • It eliminated the FEIREP oil fund, bringing heavy crude oil revenues into the budget, and reallocating resources formerly earmarked for debt buybacks toward social spending and credits aimed at reactivating the economy.

uA01bx01fig01

Primary Expenditures Real Growth

(Percent change)

Citation: IMF Staff Country Reports 2006, 098; 10.5089/9781451811827.002.A001

uA01bx01fig02

Fiscal Rule on Non-oil Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 098; 10.5089/9781451811827.002.A001

The staff’s main concerns are the following:

  • With more resources being made available to the budget, the reform has given rise to new pressures to increase spending.

  • The funds earmarked for economic reactivation are to be managed by two public development banks beset by management and institutional problems, raising the risk that the resources may be misused.

  • The earmarking of revenues for a host of expenditure categories has increased budget rigidities—a long concern in Ecuador—relative to the original law.

  • The likelihood of any heavy crude oil revenues being used for external debt buybacks, as originally intended, was further reduced.

uA01bx01fig03

Fiscal Rule on Public Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 098; 10.5089/9781451811827.002.A001

The Draft Banking Sector Law

The largest party in Congress has sponsored a draft bill that aims to channel more credit to productive activities and reduce the cost of financial intermediation. In particular, the draft legislation seeks to:

  • Cap intermediation spreads. The central bank would be required to set a ceiling on lending rates at 300 basis points above the central bank’s reference rate—the 3-month prime rate for the corporate sector—and a floor on deposit rates at 70 percent of the reference rate. All fees and commissions on loans would be abolished.

  • Direct lending to productive activities. Banks would be required to lend at least 75 percent of their deposits to productive sectors and would have to place remaining deposits in the central bank. The central bank would determine the allocation of credit among productive sectors based on their share of GDP according to the national accounts. Banks would be subject to stiff fines for non-compliance.

The authorities concur with the staff that the current draft legislation, if approved, could result in a sharp reduction in financial intermediation. Moreover, the credit allocation guidelines would likely undermine prudent credit management, thus threatening the soundness and stability of the banking system.

Congress is considering modifications to the draft bill. Amidst opposition from the financial community and warnings from the Superintendency of Banks and the central bank, Congress is reportedly considering eliminating directed lending from the bill and relaxing intermediation caps by setting them according to credit type—commercial, mortgage, consumer, and microcredit.

II. Macroeconomic Outlook and Risks

7. The inherent volatility in international oil prices and the unsteady domestic political situation imply a large degree of uncertainty for short-term macroeconomic projections. On the basis of current oil futures prices, which imply an average WTI oil price of US$61 per barrel in 2006, staff projects real GDP to grow at 2¾ percent, with non-oil GDP expanding at a similar pace. CPI inflation would fall to 3 percent in 2006, reflecting a deceleration in credit and government spending growth, while the external current account deficit would remain at about 1 percent of GDP. The NFPS surplus would rise to 4.9 percent of GDP, slightly higher than in the authorities’ program, reflecting lower capital spending which would more than offset somewhat higher current spending.

Ecuador: Main Economic Indicators, 2003–06

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8. However, the economic outlook is subject to substantial risks.

  • Spending pressures. The authorities will be challenged to keep recurrent spending and capital transfers to subnational governments within tight program limits, given the strong demands for increases from powerful interest groups, and the presence of large cash holdings from recent credit disbursements. However, such spending overruns could be partially offset by a lack of institutional capacity to execute the large capital budget.

  • Oil prices. Given the strong dependence of the budget on oil revenues, a fall in the price would substantially reduce the financing cushion for the fiscal program: every US$1 decline in the price of oil would reduce the central government overall balance by about 0.1 percent of GDP.

  • Inappropriate policy initiatives. The recent legislative changes to the FRL, pension system and tax incentives, and the banking reform bill now in Congress demonstrate that the tendency for damaging legislation is high. A continuation of this pattern could lead to a sudden sharp deterioration in confidence, with possibly serious spillover effects on the banking system.

9. In the absence of policies to address underlying vulnerabilities and advance key growth-enhancing reforms, the medium-term outlook would be characterized by low growth and an increased susceptibility to shocks that could undermine the sustainability of the dollarization system (Table 8 and Figure 6).

Table 1.

Ecuador: Selected Social and Economic Indicators

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Sources: Central Bank of Ecuador; Ministry of Finance; and Fund staff estimates and projections.

Based on percent of population aged 15+.

In 2004–06 includes a broader definition of deposits in all open financial institutions.

November data for 2005.

September data for 2005.

Table 2.

Ecuador: Central Government Operations, Net Accounting

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Sources: Ministry of Finance; Central Bank of Ecuador; and Fund staff estimates and projections.

Transfers from PetroEcuador generated by the domestic sales of oil derivatives net of derivative import costs.

Table 3.

Ecuador: Central Government Financing

(In millions of U.S. dollars)

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Sources: Ministry of Finance; Central Bank of Ecuador; and Fund staff estimates and projections.

Includes public financial institutions.

For 2005, includes bilateral financing from Venezuela in the amount of US$200 million.

Includes the refund of contributions to the social security reserve fund (totaling 2.2 percent of GDP) in 2005-06.

For 2005, reflects the value of discount given on the December 2005 bond issue.

Table 4.

Ecuador: Operations of the Nonfinancial Public Sector, Net Accounting

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Sources: Ministry of Finance; Central Bank of Ecuador; and Fund staff estimates and projections.

From 2003 onward, includes revenues accruing to the oil stabilization fund (FEIREP).

Includes the refund of contributions to the social security reserve fund (totaling 2.2 percent of GDP) in 2005-06.

Table 5.

Ecuador: Nonfinancial Public Sector Financing

(In millions of U.S. dollars)

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Sources: Ministry of Finance; Central Bank of Ecuador; and Fund staff estimates and projections.

Includes public financial institutions.

Includes financial assistance to public banks.

Includes the refund of contributions to the social security reserve fund (totaling 2.2 percent of GDP) in 2005-06.

For 2005, includes bilateral financing from Venezuela in the amount of US$200 million.

Information about the financial position of some agencies within the NFPS is incomplete.

For 2005, reflects the value of discount given on the December 2005 bond issue.

Table 6.

Ecuador: Summary Accounts of the Financial System

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Sources: Central Bank of Ecuador, and Fund staff estimates and projections.

The previous methodology included open and closed commercial banks, the new one includes only open commercial banks.

Does not exclude loan provisions starting in 2003 new methodology.

Includes the BNF, CFN, finance companies, cooperatives, savings and loans, and the BEV.

Includes the BCE, open commercial banks, and the other financial institutions.

Table 7.

Ecuador: Balance of Payments

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Sources: Central Bank of Ecuador; and Fund staff estimates and projections.

Imports of goods related to new foreign investments in the oil sector.

Includes errors and omissions.

Includes liabilities to the IMF and excludes deposits of the FEIREP oil fund.

For 2005, reflects value of discount given on the December 2005 bond issue.

Table 8.

Ecuador: Passive Medium-Term Scenario

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Sources: Ecuadoran authorities; and Fund staff estimates and projections.

September data for 2005.

Gross debt minus central government deposits.