Recent macroeconomic developments

2. Since the last Article IV consultation in July 2004, most economic indicators have evolved in a favorable manner, a reflection of enhanced confidence and a supportive external environment. Real GDP growth surpassed 3 percent in 2005, following a very strong performance in 2004, when it reached 6.9 percent. Notably, while 2004 growth had been mainly driven by the oil sector, non-oil GDP is expected to have grown faster than the aggregate in 2005, by 3.5 percent.

3. Inflation remains low, in spite of some acceleration over the last few months – CPI inflation closed 2005 at 4.4 percent, compared to 2 percent in 2004. It must be borne in mind that this acceleration has taken place against a background of convergence to inflation rates observed in the US – a critical element in a dollarized economy – which had actually ended with Ecuadorian inflation running for several months below US rates. As staff rightly observes, the recent pick-up in inflation has not implied a perceptible loss of competitiveness vis-à-vis the US. In fact, there has been a boost to Ecuador’s competitive position with respect to regional trading partners experiencing important nominal appreciations against the dollar. Since 2003, the real effective exchange rate has depreciated by nearly 10 percent. The December 2005 Inflation Report by the Central Bank of Ecuador indicates that “imported” inflation – resulting from nominal effective depreciation together with the inflation of trading partners – has had a noticeable influence on the recent price dynamics of tradeable goods in Ecuador.

4. It should also be noted that residential rents have been a key driver of the recent acceleration of inflation. Rents responded single-handedly for no less than 60 percent of the yearly inflation observed in 2005. Rental increases were not only unmatched by other nontradeable items in the consumption basket but were also very unevenly distributed across different areas of the country and types of residence. The causes of such a localized phenomenon are not entirely clear, but they would presumably involve elements of a microeconomic nature.

5. To reach a thorough understanding of the recent inflationary phenomenon in Ecuador, one ought to examine these localized and imported pressures alongside other possible suspects, including growth in credit and fiscal spending. Such examination would shed important light on what could have reasonably been achieved in 2005 with a counterfactual stance towards aggregate demand. Anyway, my authorities are fully cognizant of the importance of controlling fiscal spending in 2006 in order to avoid a build-up of demand pressures on inflation and to rein in the propagation of any exogenous inflationary shocks.

6. Enormous efforts to maintain a prudent fiscal policy have been a critical element in the authorities’ strategy to consolidate macroeconomic stability and enhance private sector confidence. Staff indicates that the non-oil primary balance has deteriorated between 2003 and 2005, with the deficit of the central government increasing from 1 percent to 3 percent of GDP. It must be noted, however, that the net contribution of domestic sales of petroleum derivatives (which are classified as non-oil revenues) alone, during that period, fell by a total of 2.2 percentage points of GDP. This deteriorating component reflects the fact that domestic prices of petroleum derivatives have not been kept in alignment with international prices, a policy followed by several countries besides Ecuador when their social safety nets are unable to provide the poor with targeted relief from soaring energy costs. This component of the government’s net spending would be automatically scaled back in tandem with a drop in international oil prices, a crucial consideration for any assessment of the budget’s overall vulnerability to oil revenue fluctuations.

7. My authorities, however, recognize as imperative to keep in check the increase in the non-oil deficit, as witnessed most recently by the President’s Executive Decree of January 13 reducing the projected 2006 budget deficit by US$316 million. They are also aware of the inherently distortionary character of the subsidies to oil derivatives. Regarding the latter, they consider a bottom-up approach to raising public awareness about the inefficiency and inequity of the subsidies to be a critical first step that could, under more propitious political conditions, eventually lead to their reduction. Accordingly, they will encourage and support civil society initiatives to put the theme in the public domain and help disseminate the necessary information.

8. The non-financial public sector (NFPS) has been consistently posting primary surpluses between 4 and 5 percent of GDP, and its overall surplus has hovered around 2 percent of GDP. As a result, the public debt burden has been declining and is set to continue to do so. The net debt of the NFPS is projected to have closed 2005 at 34 percent of GDP, down 4 percentage points from 2004, 11 percentage points from 2003, and a staggering 30 percentage points since 2001. Evidently, the fiscal position could have been even better if the recent upsurge in oil prices had been allowed to reflect itself in an improved overall primary surplus. My authorities are well aware of the policy options they have been facing in the fiscal front in the recent past. On the one hand, there is the option favored by staff of devoting most of if not all the oil windfall to increase the overall primary surplus and to further accelerate the process of fiscal consolidation and debt reduction. The technical merits of such an option are evident. However, it is a course of action that seldom passes the test of political reality, and understandably so in countries like Ecuador, where the fiscal indicators are reckoned by staff to be “generally superior” among Latin American and emerging market economies (Selected Issues, chapter I, paragraph 29), debt reduction is already making considerable progress, and dire social needs renders it very challenging to maintain expenditure constant in face of buoyant oil prices.

9. Foreign financial conditions have been favorable, and Ecuador has made good use of them. In late 2005, and for the first time in eight years, the government successfully placed a 10-year global bond for $595 million. The proceeds of this issuance are to be entirely devoted to repaying or buying back other debt obligations. Notwithstanding the rapid rate of growth of imports, the external current account deficit has remained stable, at only around 1 percent of GDP, comfortably financed by both oil and non-oil FDI.

10. In the domestic financial front, the most salient feature has been the robust increase in bank deposits, a clear sign of confidence in the financial system in general, and in the sustainability of dollarization in particular. As a result, credit to the private sector continues in a salutary process of recovery from the contraction caused by the 1999 banking crisis, in a context of declining non-performing loans and continuous increase in the capital-to-assets ratio. Credit has not yet rebounded completely from the losses associated with the crisis, and the recovery of financial intermediation, if anything, had been deemed too slow. It is in that light that one should assess the acceleration in credit growth observed in 2005, bearing in mind also that the Ecuadorian economy displays one of the lowest ratios of credit to GDP among comparable economies in the region – regional standards being themselves far from stellar – and that enhancing financial intermediation remains a key policy objective.

Structural reforms

11. While the extremely complicated political situation has not derailed the government’s efforts at consolidating macroeconomic stability, it has certainly played a decisive role in delaying the reform agenda. The limited action that has taken place in that front is the direct result of the difficulties faced by a government that does not hold a majority in Congress – it is actually not affiliated with any political party – when most structural reforms require congressional approval and the political climate is hotly contested. In all candor, my authorities admit that the electoral calendar – with general elections scheduled for October – is unlikely to make the political situation any easier over the coming months.

12. The reform agenda is long and I shall not delve into the many items on the merits of which staff and my authorities broadly agree, and which were endorsed by the Executive Board during the last Article IV consultation. As staff reports, the authorities are ready to advance preparatory technical work on a number of items, relying in some cases on technical assistance from the Fund and from other multilateral institutions. Broader overtures in the attempt to build social consensus, however, would need to be managed with care in order not to jam the political radar screen and to prevent negative partisan positions towards specific reforms from becoming overly crystallized if caught into the heat of the electoral debate.

13. My authorities feel, however, that important clarifications are in order regarding the changes made to the Fiscal Responsibility Law (FRL) and to the Social Security Institute’s (IESS) reserve fund, both of which, staff contends, amounted to a serious weakening of the overall fiscal framework. First of all, with respect to the decision to return assets in the IESS reserve fund to employees after three years, it is important to clarify that this was by no means a government initiative. On the contrary, given the decision of Congress, the government did all it could to mitigate the adverse fiscal implications by setting up a manageable schedule for the mandated transfers.

14. With regard to the FRL, it is imperative to bear in mind that prior to the changes introduced in 2005, the law established (i) a declining ceiling on public debt; (ii) a path for the non-oil fiscal deficit; (iii) a ceiling on the rate of growth of primary expenditure. Only the latter restriction was partially modified, with the cap now applying to the rate of growth of current expenditure. With the interlocking checks on debt, deficits and expenditures that remain in force, my authorities are confident that further satisfactory progress in fiscal consolidation will not be jeopardized by the extra degree of freedom targeted at investment spending.

15. On the elimination of the FEIREP oil fund, also part of the FRL amendment, a few clarifications are also in order. Originally, the purpose of FEIREP was to devote 70 percent of its resources to retire debt, 20 percent for stabilization, and the rest for social expenditure. This administration opted for a different arrangement that calls for resources to be incorporated into the budget, to finance debt buybacks, investment projects and social spending. It should be noted that, when FEIREP was eliminated, there were no accumulated resources in the stabilization account, and the debt retirement account had been repeatedly used to finance spending, through operations in which debt was formally retired with FEIREP funds but an equivalent amount returned right away to the government’s coffers in exchange for newly issued debt. Multiple reasons lie behind the decision to eliminate FEIREP, but first and foremost the need to address critical expenditure needs both in the social sectors and with regard to public infrastructure. To this effect, the government has been faithful to its commitment not to use any of the funds to finance wages and pensions.

16. My authorities consider the modifications in the FRL – including the elimination of FEIREP – instrumental to make budgetary management viable under strict compliance with these legal provisions, to which they are fully committed. Ensuring that the additional revenues brought on-budget will be put to the most efficient use – including debt retirement – is certainly a challenge of which they are aware. Meeting that challenge has been placed at the very top of their priority list, and the authorities are on record stating so much in no uncertain terms. To that effect, the Ministry of the Economy is currently designing procedures to ensure that ex-FEIREP resources are allocated on a competitive basis and in accordance with economic merit rather than political pressure. The intention is to put in place safeguards that will effectively protect these funds from the imperfections in the preexisting system of resource allocation, including those pointed out by staff with respect to the operations of the public development banks – their improvement being itself another top priority of the economic team. The government has declared that these resources will not be allocated until adequate safeguards are in place.

17. Regarding the financial sector, my authorities are in the process of addressing many of the issues highlighted in the 2004 FSAP. Recently, the banking superintendency has tightened regulations regarding capital and liquidity, and Congress approved legislation strengthening credit bureaus and incorporating a new AML framework. The authorities also agree with staff on the deleterious effects of the financial sector reform recently proposed in Congress, a reform that caps intermediation spreads and directs lending to specific productive activities. While it is certainly the case that intermediation spreads remain high and that some sectors rightly complain about difficulties in accessing credit, the government fully understands that the remedies proposed by Congress will likely make matters worse, not better. The Ministry of the Economy, the Central Bank of Ecuador and the Internal Revenue Service are joining forces to design policies capable of addressing legitimate concerns about high bank spreads and service fees without negatively impacting the solidity and efficiency of the financial sector.

Medium-term outlook

18. My authorities take note of the medium-term scenarios presented by staff, and agree with their broad qualitative features despite the huge uncertainty necessarily surrounding any attempt to turn such scenarios into quantitative forecasts. In particular, they acknowledge that growth would be considerably enhanced by progress in key reforms, and that faster growth would translate into higher fiscal revenue and a faster decline in the debt-to-GDP ratio. They are heartened, though, by the conclusion that the debt burden would continue declining even in the no-reform scenario, reaching just over 30 percent of GDP in 2010. While important to consolidate confidence in the resilience of fiscal consolidation, that conclusion is obviously no grounds for complacency since any rate of growth similar to that forecasted in the passive scenario would fall way short of what Ecuador requires to make a serious dent on poverty and unemployment. That being the case, my authorities reiterate their commitment to macroeconomic stability and to make every effort to advance the reform agenda –albeit in an adverse political context that should not be conducive to great progress in the short run.