Ecuador: Staff Report for the 2015 Article IV Consultation

Article IV discussions with Ecuador were conducted on-site for the first time since 2007 (Annex I). After growing at an average of about 41/2 percent over the past decade-on the wave of high oil prices, a strong public investment agenda, and the anchor of full dollarization-the economy has been hit by significant external shocks since late 2014. The sharp decline in oil prices and significant real exchange rate appreciation have undercut exports and fiscal revenues. The authorities responded rapidly with a large fiscal adjustment, introduction of temporary import surcharges, and moderation of minimum wage growth. The economy is projected to contract in 2015 and growth to remain subdued in 2016, while medium-term potential has been revised down given prospects of lower investment and employment growth.

Abstract

Article IV discussions with Ecuador were conducted on-site for the first time since 2007 (Annex I). After growing at an average of about 41/2 percent over the past decade-on the wave of high oil prices, a strong public investment agenda, and the anchor of full dollarization-the economy has been hit by significant external shocks since late 2014. The sharp decline in oil prices and significant real exchange rate appreciation have undercut exports and fiscal revenues. The authorities responded rapidly with a large fiscal adjustment, introduction of temporary import surcharges, and moderation of minimum wage growth. The economy is projected to contract in 2015 and growth to remain subdued in 2016, while medium-term potential has been revised down given prospects of lower investment and employment growth.

Context

1. Ecuador pursued a strategy of public sector-led growth during the oil boom, which yielded important social benefits. It was spearheaded by President Correa, since his election in 2007. His Patria Altiva y Soberana (PAIS) coalition holds a majority in congress; however, government poll ratings have been declining in 2015, until recently. President Correa can run in the 2017 presidential election only if the constitution is changed to allow reelection for a third term.

2. Growth averaged 4½ percent over the past decade—contributing to a solid improvement in social indicators—supported by the positive terms of trade and large public investments. Reflecting Ecuador’s goals of diversifying energy production and improving infrastructure and social equity, the overall fiscal position of the non-financial public sector (NFPS) widened from a balance in 2011 to a deficit of 3½ percent of GDP in 2012–14—despite high oil prices—mainly driven by high capital spending. During the same period public debt rose about 9½ percentage points to 31.3 percent of GDP. Between 2006 and 2014, the poverty rate declined from 38 percent to 22.5 percent and the GINI coefficient from 0.54 to 0.47 in 2014, while the unemployment rate fell significantly. In 2014, the reference household income exceeded for the first time the cost of the basic consumption basket. Social convergence was in part achieved through growth in real wages in excess of productivity, which contributed to maintaining inflation at about 4 percent over the decade. Financial stability was preserved, supported by dollarization. In 2014, growth moderated to 3.8 percent, but remained higher than in the rest of the region—as in the past 7 years.

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Ecuador: Oil Prices and Economic Performance

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Sources: National Authorities; IMF (WEO); and Fund staff calculations.

3. Since the third quarter of 2014, the economy has suffered external shocks. The sharp decline in the international oil price (from US$97.5/barrel in 2014Q2 to below US$40/barrel in August 2015, for Ecuadorian mix) significantly undercut oil exports. The net oil balance declined by almost US$2.4 billion, yoy, for the January–June 2015 period. In addition, the real exchange rate (REER) appreciated by about 16 percent in June 2015, yoy, and there is now evidence of overvaluation (see Annex II).

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Ecuador: Real Effective Exchange Rate

(Average 1995–2015 = 100)

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Source: IMF’s International Financial Statistics.

4. The authorities responded to the shocks by implementing a strong fiscal adjustment plan, introducing balance of payment safeguards, and containing minimum wage growth. Spending was cut significantly and tax measures enacted, aiming at containing the fiscal deficit to the level envisaged in the original budget (see below). A freeze in public sector wages was announced for 2015 and the increase of the private minimum wage limited to 4.1 percent (from an average of 9 percent over the previous 7 years). On March 6, 2015, tariff surcharges were introduced on about 30 percent of imports for 15 months, which contributed to the decline in non-oil imports by 15 percent, yoy, in June, with durables and transport equipment taking the largest hit (of around 32 percent each).1, 2

5. Access to international credit has tightened substantially. The spread paid by the government over U.S. Treasuries rose from 530 bps in June 2014 to 900 bps in March 2015 when a US$750 million 5-year bond was issued.3 The spread declined in May, when the bond was reopened (for another US$750 million), but has subsequently risen again, to above 1,300 at end-August. The movements in spreads broadly reflect the movements in oil prices, but are much larger than those experienced by other countries with similar oil dependence or similar spreads in the first half of 2014. In recent months, the increase in spreads is also due to concerns about natural disasters and internal debates on policy reforms. Net International Reserves (NIR) were about US$4.8 billion at end-July, around 2½ months of imports (Annex II).

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Ecuador: Sovereign Yields and Country Risk

(In basis points)

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Source: Bloomberg.
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Selected Comparator Countries: Sovereign Spread

(In basis points)

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Source: Bloomberg.
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Changes in EMBI Spread and Oil Exports

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Source: Fund staff estimates.
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Ecuador: Economic Activity and Consumer Confidence

(Three-Month Moving Average)

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Sources: Central Bank of Ecuador and Fund staff calculations.
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Ecuador: Deposits and Credit at Private Banks

(In percent, year-on-year change)

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Sources: Superintendency of Banks.

6. Economic growth is slowing and financial system’s liquidity is declining. Activity and consumer confidence declined sharply in the first half of 2015, and real GDP growth moderated to 3 percent (yoy) in Q1 2015. Inflation remains elevated, at 4.2 percent (yoy) in August 2015, reflecting changes in transport tariffs as well as in food and utilities prices. While the financial system remained well capitalized and liquid in 2014, private sector deposits declined by about US$2 billion from December 2014 to July 2015 (after growing by 11 percent in 2014), reflecting both an adjustment to the shocks and weakening confidence, and creating pockets of weaknesses in the financial system.4 Banks’ liquidity has declined (by about US$1.7 billion, by end-July), and banks have started to ration credit, which is affecting even the highest-quality customers. Over the same period, total non-performing loans have risen from 2.9 to 3.8 percent, especially in consumer, microfinance, and education loans. Nonetheless, main soundness indicators did not show signs of strain (Annex IV) and the authorities noted that the system remained sound and solvent.

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Ecuador: Liquidity of Private Banks

(Billions of U.S. dollars)

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Source: Superintendency of Banks.1/ Liquid Assets to Short-Term Liabilities.
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Ecuador: Inflation Decomposition

(contribution to year-on-year inflation)

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Source: Central Bank of Ecuador.

Risks and Outlook

7. Due to shocks and expected adjustments, the economy is projected to contract slightly in 2015, while the external position deteriorates. Growth is expected to slow to about negative ½percent in 2015, and to remain around zero in 2016. Accordingly, unemployment is likely to edge up. Inflation is expected to stay elevated, about 3½ percent at end-2015, before moderating to about 1½ percent in the medium term. The 2015 current account deficit is projected to worsen to about 2½ percent of GDP, with a deterioration of the oil balance by about 4 percent of GDP being partly compensated by a decline in non-oil imports (following the imposition of tariff surcharges, scaled-back public investment, and consumption slowdown, which—combined—more than offset the effect of the real exchange rate appreciation).

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Ecuador: Unemployment and Output Gap

(In percent)

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Sources: Ecuador National Authorities and Fund staff calculations.

8. The persistent effect of the shocks is expected to imply lower growth and a weaker financial system into the medium term. Ecuador’s medium-term potential growth has been revised down to about 3 percent, due to the effect of lower oil prices on investment and production as well as more limited scope for employment growth (Box 1). Growth is projected to remain below potential, until competitiveness is restored and the real exchange rate overvaluation eliminated. Inflation is expected to decline, after a temporary upward impact from the surcharges. The less favorable growth outlook and weaker confidence, as well as the U.S. monetary policy normalization, can be expected to put additional pressure on financial sector stability (by deteriorating the quality of bank assets and raising credit risk) and increase funding costs, thus setting the stage for unfavorable macro-financial dynamics. The authorities agreed that the adjustment is going to be difficult but considered the economy to be more resilient than in the staff’s scenario. At the time of the mission, they projected growth at 1.9 percent in 2015 and 3.9 percent in 2016, driven by private consumption and investment.

9. Moreover, risks to the outlook are tilted to the downside. Main external risks are additional weakness in oil prices, global financial instability, persistent dollar appreciation, and weak growth of trading partners. Ecuador-specific risks center on limits to the availability of external financing, potential domestic financial system pressure associated with the economic adjustment and uncertainty about the policy response, delays in enhancing the country’s energy balance, as well as possible natural disasters (including from El Niño and volcanic activity). On the upside, future oil production could be higher, especially if oil prices rise again facilitating the financing of larger investment plans.

Risk Assessment Matrix1

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The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

Policy Discussions

The current fiscal adjustment plan can be expected to absorb the fiscal consequences of the external shocks, but a broader strategy is called for to preserve macro and financial stability, bolster confidence, and restore competitiveness. A fiscal contingency plan should be in place to offset any financing shortfalls. The retention of adequate liquidity in the financial sector must be an over-arching objective, while financial sector regulation and supervision need to be upgraded. Regaining competitiveness and reviving growth will require further wage containment and improvements in the business environment, while policy buffers should be rebuilt as insurance against downside risks.

A. Fiscal Adjustment to External Shocks

Near-term outlook

10. The current fiscal adjustment plan should offset the fiscal impact from the oil shock in the near term, while balancing the need to contain the contractionary effect of fiscal policy. The revision to the 2015 budget (originally published in October 2014) envisages that the decline in the net oil export revenue due to the shock will be mostly offset by expenditure cuts, leaving the overall fiscal balance broadly unchanged. Capital spending is planned to be cut by about 1.8 percent of GDP compared to the original budget (mainly with postponement of new projects in infrastructure and schools), while current expenditure will be trimmed by about 1.7 percent of GDP (mostly on goods and services and social transfers).5 Compared to 2014, however, current expenditure is expected to increase while the adjustment falls entirely on capital expenditure. In the revision to the 2015 budget, higher tax revenue (than originally anticipated) from recently introduced changes to the tax system, a tax amnesty, and the import surcharges, will be partially offset by a reduction in non-tax revenue associated with the downturn and a downward revision in the social security contribution. Indeed, tax revenue collection in the first half of the year was better than anticipated. The authorities have for now withdrawn recent proposals to increase inheritance and real estate capital gains taxes, given strong public opposition. Staff projections are similar to the revised budget, with some differences in non-oil revenues—mainly reflecting differences in GDP growth assumptions—and capital spending.

Ecuador: The Impact of the Oil Price Shock and Fiscal Adjustment, 2015

(In percent of GDP, unless otherwise indicated)

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Sources: Ministry of Finance and Fund staff projections.

In percent of GDP pojected by IMF. The initial budget, approved in October 2014, was revised in August 2015.

Estimated from the BOP export revenues. The actual fiscal revenues may differ slightly from these amounts due to differences in recording time between the BOP and Fiscal accounts.

Ecuador: Non-Financial Public Sector Financing

(In percent of GDP)

article image
Source: Ministry of Finance.

Includes financing through advance sales of oil.

Domestic financing includes change in government deposits.

11. Despite the fiscal adjustment, financing needs remain large and heavily dependent on external borrowing. Including the expected amortizations of US$650 million of the 2015 global bond and about US$1.7 billion of advance oil sales, total amortization will reach about US$5.1 billion (5.2 percent of GDP). Gross financing needs will be about 10.3 percent of GDP in 2015, of which 5.6 percent of GDP was secured in the first half of the year. Full execution of the budget will depend especially on the remaining external financing plans (about 3.7 percent of GDP), of which about 1 percent of GDP is fully committed so far from China, CAF and IDB.

12. Any shortfall in financing or a significant deterioration in market access will have to be addressed through further spending retrenchments. The need to preserve full backing for dollarization and assure private sector confidence in the monetary regime implies that central bank financing and government arrears will have to be avoided. Staff underscored that a fiscal contingency plan should be in place to address potential financing shortfalls through further cuts of lower-priority capital or current spending—while preserving high-priority ongoing hydroelectric and infrastructure projects—thus avoiding a liquidity decline in the financial system or delays in payments. Moreover, the authorities will need to make every effort to improve market access and lower spreads—also in light of the impending increase in U.S. interest rates—as well as deter capital outflows, particularly by strengthening private sector confidence in growth and policy prospects.

13. The authorities are confident that the expected financing will be secured and the revised budget will be fully executed. They agreed that financing shortfalls will need to be matched by cuts in lower-priority capital projects. They reiterated that financing from the central bank was done on a short-term basis to give the budget execution some flexibility while awaiting external disbursements, and will be discontinued by end-year.

14. The 2016 draft budget, which is not finalized yet, envisages further fiscal consolidations with the overall deficit declining to 3.7 percent of GDP. Oil revenue is expected to decline further based on an oil price assumption of US$40/barrel. However, this would be more than offset by corresponding expenditure retrenchments, with an improvement in the overall balance of about 1½ percent of GDP.

Medium-Term Fiscal Challenges

15. The authorities plan to reduce the fiscal deficit to 0.5 percent of GDP by 2018. In the medium term, the authorities plan to anchor the public sector wage bill to inflation and to contain growth in spending on goods and services and social transfers below GDP growth. They view the ongoing investment in hydroelectricity at the core of their plan to rationalize fuel subsidies—through, notably, switching from gas to electricity for domestic cooking, with annual savings of about US$0.9 billion starting in 2017 when the process is completed. At the same time, they plan to invest about US$4.3 billion over the medium term to develop the Ishpingo-Tambococha-Tiputini (ITT) oil fields and increase oil production by about 52 million barrels a year by 2020 from the current level of about 200 million. The public oil company, Petroamazonas, is expected to undertake the investment in cooperation with private sector service providers, with financing from international banks covered by sovereign guarantees.

16. Reflecting more cautious assumptions about oil investment, staff’s baseline scenario envisages progressive fiscal consolidation to reach a deficit of about ½ percent of GDP in 2020. At current oil prices and given Petroamazonas’ limited financial and technical capabilities, the scenario assumes an increase in oil investment sufficient to ensure that new production offsets declining production from ageing fields, so that oil production remains flat. Under staff’s baseline scenario, gross public debt excluding advance oil sales, which is the official definition, reaches the legal limit of 40 percent of GDP in 2018 before declining to 39 percent of GDP in 2020, leaving virtually no space for countercyclical policy in the face of potential shocks.6 The medium-term primary surplus of about 2.3 percent of GDP—to be reached progressively by 2020—is consistent with debt sustainability, and the medium-term non-oil primary deficit of about 0.7 percent of GDP is consistent with the long-term Fiscal Sustainability Framework (Annex III). Given the high financing needs and rapid accumulation of public debt, the envisaged fiscal adjustment will be required. If market conditions remain adverse and financing shortfalls materialize over the medium term, fiscal adjustment will need to become more front-loaded and rely not only on additional investment cuts, but also on a more comprehensive expenditure rationalization.

17. It will be important to rebuild fiscal buffers once the fiscal position strengthens and financing conditions improve. The recent external shocks have underscored the need to be able to mobilize timely financing, highlighting the importance of fiscal buffers in the form, for example, of stabilization funds to cope with downside risks (including natural disasters like those potentially arising from the Cotopaxi and el Niño). Also, to enhance transparency of public asset and liability positions, it would be valuable to publish detailed information on advance oil sales, delayed payments of the Secretaría de Hidrocarburos, debt issued to the BCE, short-term debt, and contingent liabilities.

18. Staff advised additional complementary fiscal measures going forward. These include:

  • Maintaining this year’s freeze on public sector wage rates into the medium term. This would also help to restore competitiveness, given the effect on private sector wage determination in an integrated labor market (more on this below); any alternative measure of fiscal consolidation could also contribute to the needed relative price adjustment.

  • In line with the authorities’ intentions, overhauling the fuel subsidy system, not only through ongoing projects to enhance hydro energy, but also through better targeting subsidies to the poor and allowing domestic fuel prices to reflect international conditions.

  • Improving tax collection, through further enhancing administrative efficiency and enforcement (closing tax loopholes and addressing tax evasion), while reducing tax expenditures and deductions from personal income tax. Tax amnesties should be avoided, given their effect on expectations of further amnesties.

  • Start addressing the expected shortfall in the pension system—which is expected to contribute negatively to the budget in the 2030s—by gradually increasing retirement age and anchoring pension benefits to lifetime contributions, while increasing efforts to reduce labor market informality.

  • Developing communication on the medium-term fiscal framework and strategy. Timely announcements on revisions to medium-term plans will be instrumental to enhancing confidence.

19. The authorities broadly agreed with staff suggestions—and indicated they are already undertaking some of the mentioned reforms—but underscored the need to balance political sensitivities in pursuing these objectives. They indicated that their current plans to anchor public sector wage growth to inflation, together with productivity gains arising from the improvement in human capital, infrastructure, the energy balance, and the interaction with the private sector are sufficient to address competitiveness issues (more below). The authorities’ plans for fuel subsidy rationalization envisage inducing consumers to switch from gas to electricity for domestic cooking. While highlighting their past advances, the authorities agreed that additional efforts are needed to improve the efficiency of tax collection. They clarified that they have no intention of repeating the tax amnesty. Finally, the authorities continue to believe that public savings should be deployed towards high-return projects related to the economic and social development of Ecuador rather than set aside in low-return fiscal funds.

B. Ensuring Financial Stability and System Liquidity

20. For a dollarized economy, preservation of liquidity at the central bank (BCE) and private banks must always take priority. This is especially important now, to limit systemic effects on the financial system from the recent shocks and subsequent slowdown, deterioration in confidence, and possible vicious cycle through macro-financial linkages (see Annex IV). The authorities should continue their frequent monitoring of liquidity—and if pressures persist, promptly adjust reserve requirements at the BCE. Current policies that affect liquidity need to be reversed:

  • The BCE has been providing direct financing to the government since October 2014. Even if temporary, this raises concerns about ensuring central bank liquidity, in light of uncertainty of external disbursements, as well as about monetization of public spending. The authorities’ plan to discontinue such financing within a few months is highly welcome.7

  • The BCE has also been providing credit to public corporations. Such credit—about US$1.8 billion in July 2015—affects the BCE balance sheet. Its provision should therefore be closely linked to conservative scenarios of potential liquidity needs for the BCE, to ensure that BCE obligations with both banks and the public sector can be fulfilled on demand. The authorities explained that they carefully program the liquidity position of the BCE on a quarterly basis to ensure adequate liquidity.

  • A countercyclical measure announced in March 2015 envisages the provision of directed mortgage lending through private banks. This requires banks to extend credit at a time when they need to maintain liquidity and contain credit growth in order to cope with the ongoing deposit withdrawal. Moreover, the associated mortgage securitization scheme backed by the BCE could also create liquidity pressure for the BCE itself (and contingent liabilities to the government), given default risks. The authorities stated that the liquidity levels and credit growth of the financial system are being carefully monitored and assessed quarterly, and any undue pressure on the system would lead to adjusting the lending targets.

  • The long-standing domestic liquidity requirements on banks were tightened further in 2012. These affect the quality of banks’ liquidity: coupled with the 3 percent tax on banks’ external liquid assets, they force banks to hold substantial liquidity domestically, either at the central bank (which can be then lent to public banks) or in domestic debt instruments (for which there is not an active secondary market), thus impairing banks’ optimal liquidity management (by limiting how liquid, diversifiable, and safe is the liquidity portfolio), especially for small banks.

21. The public’s concerns about the proliferation of possible alternative money arrangements need to be dispelled. In particular, it would be important to allay any fears of monetization of public spending.

  • The electronic money system introduced by the BCE in December 2014 is backed by liquid assets (activos liquidos). However, to maintain credibility, accounts should be explicitly backed by international highly-rated dollar-denominated liquid assets, and the authorities are planning to issue a regulation clarifying that this is indeed the intention. The funds fully remain the property of the account holder and there is no co-mingling of accounts, but they are fungible for the purpose of NIR management. The participation in such a scheme should remain voluntary, as originally planned. The authorities see this scheme as a way to reduce currency in circulation, as wear and tear of the bills implies a replacement cost for the BCE (about US$3 million per year), and argue that carrying the funds on the BCE balance sheet (rather than as an escrow account) bodes well for transparency.

  • A recent resolution authorizes the government to pay for services with BCE securities, and taxpayers may use such securities for tax amnesty payments. This should be discontinued once the tax amnesty expires and issuance of bonds should be capped at the current legal limit of US$50 million. The authorities indicated that this scheme is very effective and functions purely as a clearing house between the government and the private sector, since these securities can only be used for tax payment purposes and cannot be traded or transferred.

22. Crisis management arrangements should be improved.

  • The speed and confidentiality of access to the Liquidity Fund should be explicitly outlined in financial regulations in order to enhance confidence.8 Also, the authorities should clarify that the assets of the Liquidity Fund, set up with the contributions of banks to provide liquidity at the time of pressure, will continue to be invested only in highly rated international securities, as is the case at present, dispelling public concerns resulting from overlapping regulations on the matter. The authorities stated that they were reviewing regulations for consistency and would clarify any confusing points if necessary.

  • The deposit insurance fund is overexposed to public debt and other domestic assets for which there is not an active secondary market. Best international practices suggest investing these funds in high quality securities, to ensure their liquidity and safety. Staff also advised against the cross-borrowing arrangements between the two deposit insurance funds (for private banks and cooperatives). The authorities aim to achieve a well diversified and liquid portfolio gradually, while at the same time their intention has always been to invest the deposit insurance funds in productive domestic assets rather than in low-yielding liquid securities abroad. They also do not see any liquidity pressures arising from selling the assets when paying out depositors, given the gradual timeframe associated with bank resolution.

23. Reducing administrative controls on banks would enhance financial efficiency and stability.

  • The caps on lending interest rates distort banks’ business decisions and risk assessments, and price some customers out of the market. Gradually lifting these caps would allow banks some margin to increase deposit rates in the context both of declining deposits and the expected U.S. monetary policy normalization. To mitigate any risks associated with the liberalization of interest rates, the authorities should consider introducing risk management tools such as tailoring concentration limits, adjusting sectoral risk weighted capital requirements, and monitoring loan-to-value ratios and credit gaps. The authorities are concerned about the adverse selection bias as the system is historically highly concentrated, but are open to learning in greater detail about possible policy tools that could mitigate this concern.

  • An unlevel playing field in the mortgage market distorts competition. The authorities should assess the implications of the special advantage of the bank of the pension fund (BIESS) in providing extensive mortgage lending (US$7 billion), in terms of cheaper access to credit and unique ability to collateralize payments with salaries.

24. Efforts to enhance broader financial sector supervision and regulation need to continue, together with strengthening the anti-money laundering and combating the financing of terrorism (AML/CFT) framework. Over the past several years, the authorities have taken steps to strengthen the financial system and safeguard liquidity. Since the 2004 FSAP, the Superintendency of Banks (SBS) implemented intense training programs for supervisors. Progress has been made in complying with Basel criteria, improving supervision of off-shore banks, and eliminating regulatory forbearance on bank loan classification. The authorities expressed interest in enhancing their stress-testing toolkit and more broadly on monitoring systemic risk, including through network analysis. Over the medium-term, the frameworks focusing on creditor rights, bank liquidation procedures, indebtedness assessments, and collateral resolution should be strengthened. Making sure that new regulations regarding the credit bureau continue to meet best international practice would also be essential to improve risk assessment and financial sector efficiency. Staff strongly suggested undertaking a new FSAP, and the authorities are currently reviewing the 2004 FSAP’s conclusions to determine the necessity of a new one. Although significant progress has been made to improve the AML/CFT framework, continued political commitment and sustained implementation of AML/CFT measures are needed to exit the Financial Action Task Force monitoring, so as to safeguard financial stability from reputational risks.

C. Restoring Competitiveness and Promoting Private Sector Participation

25. Significant efforts to regain competitiveness are crucial to preserve external balance and dollarization, and to sustain healthy medium-term growth. While the country’s external position was assessed to be broadly consistent with the medium-term outlook as of 2014, the steep fall in oil prices and the REER appreciation will require not only a significant improvement in the fiscal position but also a substantial real wage and price adjustment to reverse overvaluation, while achieving an improvement in access to market financing (Annex II). To safeguard external balance, the authorities have applied various measures over the past several years, such as a tax on transfers abroad (5 percent) since 2007,9 a tax on liquid assets held abroad by financial institutions since 2008, and quality controls on imports since 2013. In 2015, import surcharges have been imposed.

26. Staff underscored that the recent import surcharges should be removed as soon as possible, and within the announced timeframe, given the distortionary nature of such measures. The authorities stated that they are committed to a gradual elimination of the surcharges as well as to continuing the consultation with the WTO Balance of Payment Committee. They also indicated that the cuts in investment spending planned for the medium term fall heavily on imports, which would help cushion the impact of the elimination of the tariffs. Staff reiterated also the need to gradually dismantle the tax on transfers, as conditions permit, along with a gradual lifting of caps on lending interest rates. The authorities see this tax as a successful tool to prevent short-term capital outflows that create financial instability. In order to facilitate long-term capital inflows, they recently decided to eliminate the tax on transfers associated with bank loans of more than one year for lending to the sectors specified in the Production code (e.g. housing and micro lending). Staff recommended that such exemption be extended to all transfers associated with long-term inflows, and to eliminate the discretion of the Monetary and Financial Policy Board on the terms and conditions for qualifying long-term inflows, while improving financial regulation and supervision.10

27. To regain competitiveness, substantial real wage and price adjustments are called for. The loss in competitiveness will be felt in full upon the removal of import surcharges. As real wages have increased faster than labor productivity over the past decade and the minimum wage is one of the highest in the region, restoring competitiveness in the face of the recent real exchange rate appreciation will require containing wage growth substantially below inflation for a few years. Hence the correction in wage dynamics needs to go beyond the authorities’ current plan envisaging public wages to rise with inflation and private wages to rise with inflation plus productivity. The wage adjustment should also be complemented with gains in productivity and improvements in the business environment.

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Ecuador and LA-5: Minimum Wage (2000-2014)

(In current U.S. dollars)

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Source: Haver Analytics.
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Ecuador: Labor Productivity and Real Wages 1/

(2004=100)

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Source: Haver Analytics.1/ Labor productivity refers to output per employed person.

28. The authorities have taken important steps to promote private sector participation and improve prospects for medium-term growth. They are of the opinion that the substantial reforms of the past few years aimed at improving infrastructure, human capital, and the energy balance will have persistent effects on enhancing productivity and competitiveness. In addition, recent efforts have been devoted to promoting private sector investment in agriculture, industry, and social services (with an expected impact of about US$10 billion over the next decade), including through private-public partnerships, a reduced corporate tax rate for companies investing within the productive matrix, and a tax refund for exporters on imported intermediate inputs. In their view, such productivity gains, coupled with the new wage determination strategy, will be sufficient to regain competitiveness over the medium term.

29. Broader efforts towards improving the business environment via structural reforms would greatly contribute to the restoration of competitiveness and promote the development of a well-functioning non-oil economy. International surveys cite shortcomings in the functioning of institutions, and of goods, labor, and financial markets (mainly because of insufficient competition). Thus, a wide-ranging structural reform agenda should be adopted to foster productivity, crowd-in the private sector, and attract FDI. For example, labor market rigidities should be addressed through reducing the overall cost of dismissal, promoting the availability of short-term employment contracts, and facilitating labor force participation (for example by expanding child care access). Frequent changes in the tax and regulatory systems need to be limited as they increased business uncertainty. Promoting greater trade integration, including via the finalization of the Free Trade Area with the European Union, will greatly help exporters to compete in international markets.

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Ecuador: Global Competitiveness Indicators, 2014

(Rank out of 148; 1 = best)

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Source: World Economic Forum. Note: Categories listed are those in which Ecuador ranks in the top or bottom quartile of world distribution. Some categories were omitted due to space constrains, namely: (1) Organized crime [129]; (2) Costs of terrorism [122]; (3) Degree of customer orientation [115]; (4) Country capacity to attract talent [35]; (5) Days to start a business [130]; and (6) GG budget balance [35].

Staff Appraisal

30. After a decade of growth averaging 4½ percent, supported by favorable terms of trade and large public investments, the economy is expected to contract in 2015 and growth to remain around zero in 2016. Since the third quarter of 2014, a sharp oil price drop and sizable REER appreciation affected growth and the external balance. Constrained by limited policy buffers and options, the authorities moved rapidly to announce a large fiscal adjustment to keep the deficit at the budgeted level. However, some external financing remains to be committed, while market access has become more expensive. Despite the recently imposed tariff surcharges, the current account deficit is expected to increase to about 2½ percent in 2015, while the loss of competitiveness is clouding the outlook for growth and external balance.

31. Risks are tilted to the downside. Main external risks are additional softness in oil prices which would threaten the external and fiscal positions, global financial instability which would affect access to external financing, and persistent dollar appreciation which would further erode competiveness. Domestic risks center on the availability of external financing and absence of buffers, delays in expanding energy production, natural disasters, as well as further pressure on the financial sector due to the economic and financial adjustment, existing distortions, and uncertainties about the policy response.

32. The authorities’ initial fiscal policy response to the shocks is expected to offset the fiscal implications of the external shocks, but full financing of the remaining fiscal gap is yet to be secured. The planned expenditure cuts, together with tax measures, should broadly offset the impacts of revenue shortfalls and contain the fiscal deficit within the budget level. However, the final fiscal outcome will depend on the availability of financing and a fiscal contingency plan should be in place for additional measures if needed. Financing shortfalls should be dealt with further cuts in non-priority expenditure, while short-term financing by the central bank or arrears should be avoided in the future. The import surcharges are distortionary and should be removed as soon as possible and within the announced timeline. The adjustment to the minimum wage policy and new plans to promote private sector investments—jointly with further efforts towards enhancement in human capital and infrastructure—are welcome steps, although not sufficient to handle competitiveness concerns.

33. In the near term, challenges will also center on securing adequate liquidity in the financial sector, while improving financial sector regulation. Preserving financial stability will require that the financial system remains liquid and well supervised, with financial buffers invested in highly rated securities abroad. Improving the clarity of financial regulation, stregthening crisis management and supervision are key for ensuring stability and rapid response. If pressure on the system persists, relaxing banks’ reserve requirements should be considered. Regulatory restrictions on bank activities, especially the interest rate caps and penalties on investing aboad should be lifted, and the practice of directed lending should be discontinued to allow banks to optimize thier portfolio allocation and appropriately assess risk. The system of electronic money will need to be fully backed by dollars to dispell any public preoccupation with the arrangement. The tax on transfers should be eliminated for all transactions associated with long-term inflows—as has been recently announced for such inflows when lent to specific sectors—in order to stimulate capital inflows.

34. Looking forward, it will be essential to restore competitiveness, improve the fiscal position, and enhance the business environment. Restoring competitiveness is essential to safeguard external balance and sustain healthy medium-term growth—which in turn will help preserve dollarization and financial stability. In this respect, it will be key to achieve a real wage adjustment by containing wage growth substantially below inflation for a few years, and address labor market rigidities through reducing the overall cost of employment. More broadly, reforms should be targeted at improving productivity, crowding-in the private sector, attracting FDI, and promoting trade integration. Medium-term fiscal consolidation should rely not only on spending cuts, but also on improving tax collection, overhauling the fuel subsidy system (while preserving subsidies to the poor), and adjusting the pension system, reforms which would help build fiscal buffers. Frequent changes in the tax regime and further tax amnesties should be avoided.

35. It is expected that the next Article IV consultation will take place on the standard 12-month cycle.

Ecuador: Revisiting Medium-Term Potential Output Growth1

Potential medium-term output growth has been revised down by 1½ percentage points to about 3 percent in light of the drop in the international oil prices, the associated expected decline in public investment, as well as a more limited scope for employment growth (which was associated with a large decline in unemployment in recent years). The analysis is based on a growth accounting exercise, corroborated with an empirical relationship between the price of oil and growth.

Economic activity in oil-dependent economies relies heavily on developments in the oil price. Positive commodity price shocks raise expected real income, boosting private sector confidence and investment. Moreover, in countries where the commodity sector is under the government control, such as in Ecuador, the positive price shock raises government revenue, allowing governments to invest in infrastructure and human capital. In Ecuador, public investment was raised from about 4 percent of GDP in mid-2000s to about 15 percent of GDP in recent years. As a result, the price of oil is positively correlated with capital formation and economic growth. A simple empirical estimation of just the long-run relationship between the real price of oil and economic growth shows that a 40 percent decline in the price of oil, from about US$100/barrel a year earlier to about US$60/barrel in the medium term, could lead to a decline in the growth rate of GDP by about ½ to 1½ percentage points.2

A more detailed growth accounting exercise using capital accumulation assumed in the baseline scenario, employment projection based on Okun’s law, and an empirical relationship between TFP and the real price of oil suggests that potential growth could decline by about 1½ percentage points with respect to the average growth over the past decade (see chart).

In this calculation, the effect of the decline in oil prices on investment is estimated to reduce the growth contribution of capital from 1.9 percentage points (ppts) over the past decade to about 1.4ppts in the medium term. Similarly, the contribution of labor to growth is estimated to fall from 1.4ppts in the past decade to about 1ppt in the medium term due to a slowdown in employment growth (given the more limited scope for a further reduction in unemployment from an already low level), while the contribution of human capital is assumed to remain the same. Growth of TFP is expected to slowdown from 0.9 ppts in the past decade to about 0.3ppts in the medium term, reflecting the impacts of terms of trade deterioration (based on an econometric estimate of the impact of the oil price decline on TFP growth for Ecuador).

A01ufig14

Ecuador: Contributions to Growth

(In percent)

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

1 Prepared by M. Tashu (WHD).2 The estimated long-run semi-elasticity of growth to the real price of oil is about 2, implying that a 40 percent decline in the price of oil (equivalent to a 0.5 units decline in natural log terms) entails a one percentage point decline in growth, with a confidence interval of about 1 percentage point.

Ecuador: Recent Proposals and Tax Reforms1

The government has recently introduced two tax reforms with the aim of improving tax control and increasing revenue. First, in December 2014 the National Assembly enacted the “Organic Law to Promote Production and to Prevent Tax Fraud” (Ley Orgánica de Incentivos a la Producción y Prevención del Fraude Fiscal) introducing changes to the corporate income tax (CIT) and excise laws and regulating the tax stability contracts. Second, a Tax Amnesty Law (Ley Orgánica de Remisión de Intereses, Multas y Recargos) took effect in May 2015. The government plans to raise about US$0.5 billion from each measure in 2015.

Main changes to the Tax Code and the CIT law focus on improving tax control and reducing avoidance. They include: (i) introducing in the CIT base income derived from the sale of shares or any other instruments that represent the capital of a company or a permanent establishment in Ecuador, (ii) increasing the CIT rate from 22 to 25 percent for Ecuadorian company whose owners are residents of tax havens and own more than 50 percent of the company, (iii) exempting companies for a period of 10 years for profits related to “new” and productive investments, (iv) phasing-out the exemption for interest income, unless paid by banks, (v) eliminating the deduction of expenses on junk food advertisements, (vi) introducing anti-avoidance rules (accounting and bookkeeping rules), and (vii) introducing a 35 percent withholding tax on payments to tax heaven residents. An additional measure includes increasing the excise rates on cigarettes and alcoholic beverages. Staff cautions against exempting companies for long periods.

The Tax Amnesty Law grants total relief of interest, penalties, and surcharges provided that full payment of the tax debt is made within 60 working days after May 5. The relief is reduced to 50 percent, if the full payment of the tax is made between 61 to 90 working days. Staff view is that tax amnesties are unfair for taxpayers with good compliance and weaken future compliance by raising expectations of future tax relief. Moreover, the Internal Revenue Service needs to divert resources to administer amnesties that could have been used for audits and other essential functions.

In addition, in June 2015, the government submitted two draft laws to the National Assembly to modify the inheritance tax and introduce a capital gain tax on immovable property sales. The main changes on the inheritance tax system include reducing the exempt threshold from US$77,000 to US$35,400, and significantly increasing the tax rates, placing the top marginal rates at 77.5 percent, among the highest in the world. The proposal for the tax on capital gains envisaged establishing a base as the difference between the value of the transfer and the original property cost value adjusted for inflation, and a rate of 75 percent on this base for sales’ profits over the exemption threshold of US$8,500. The government withdrew these proposals shortly after due to public opposition.

1 Prepared by R. Fenochietto (FAD).
Figure 1.
Figure 1.

Ecuador: Real Sector Developments, 2008–14

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Sources: Central Bank of Ecuador; National Statistical Institute of Ecuador (INEC); World Economic Outlook Database; and Fund staff calculations.
Figure 2.
Figure 2.

Ecuador: Fscal Sector Developments, 2008–14

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Sources: Haver Analytics;Ministry of Economy and Finance;and Fund staff calculations.1/ LA5 stands for the five largest market economies in Latin America including Brazil, Chile, Colombia, Mexico and Peru.
Figure 3.
Figure 3.

Ecuador: External Sector Developments, 2008–15

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Sources: Central Bank of Ecuador; and Fund staff calculations.
Figure 4.
Figure 4.

Ecuador: Selected Banking and Financial System, 2002–15

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Sources: Central Bank of Ecuador; Superintendency of Banks; and Fund staff calculations.
Figure 5.
Figure 5.

Ecuador: Social and Structural Indicators, 2003–14 1/

Citation: IMF Staff Country Reports 2015, 289; 10.5089/9781513519074.002.A001

Sources: National Authorities; World Development Indicators; Global Competitiveness Report and IMF staff estimates and calculations.1/ Green dots correspond to LAC countries.
Table 1.

Ecuador: Selected Economic and Financial Indicators

article image
Sources: Central Bank of Ecuador; Ministry of Finance; Haver; World Bank (WDI); and Fund staff estimates and projections.

The negative contribution in 2018 reflects the planned closure of the main oil refinery for maintenance, and the associated fall (increase) in refined oil exports (imports). The refinery is expected to reopen in 2019.

The official public debt definition does not include the outstanding balance for advance oil sales, which was about 1.5 percent of GDP at end-2014.

Includes inventories.

Table 2.

Ecuador: Operations of the Nonfinancial Public Sector, Net Accounting

(In millions of U.S. dollars, unless otherwise indicated)

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

Net of operational cost.

From 2011 on, includes additional public pension sytems which previously had not been consolidated into the NFPS accounts.

Reflects service contract payments to private oil companies beginning in 2011.

Oil revenue plus profits of state-owned oil companies, which is retained for investment in the oil sector, less oil-related current expenditure (the costs of imports of oil derivatives and payments to private oil companies).

The primary balance plus current oil balance, less profits of state-owned oil companies, which is offset by a corresponding oil investment under capital expenditure.

Table 3.

Ecuador: Operations of the Nonfinancial Public Sector, Net Accounting

(In percent of GDP, unless otherwise indicated)

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

Net of operational cost.

From 2011 on, includes additional public pension sytems which previously had not been consolidated into the NFPS accounts.

Reflects service contract payments to private oil companies beginning in 2011.

Oil revenue plus profits of state-owned oil companies, which is retained for investment in the oil sector, less oil-related current expenditure (the costs of imports of oil derivatives and payments to private oil companies).

The primary balance plus current oil balance, less profits of state-owned oil companies, which is offset by a corresponding oil investment under capital expenditure.

Change in structural nonoil primary balance.

Table 4.

Ecuador: Nonfinancial Public Sector Financing

(In millions of U.S. dollars, unless otherwise indicated)

article image
Sources: Ministry of Finance; Central Bank of Ecuador; and Fund staff estimates

Includes domestic floating debt and statistical discrepancy.

Includes deposits of pension funds, which are reported as nonfinancial public sector.

Does not include outstanding treasury certificates or arrears.