Publish in Perspectives - Wednesday, February 26, 2020
Ecuador President Lenin Moreno faced protests last year when he tried to raise fuel prices. He is trying to pass key reforms to tamp down the fiscal deficit. (Photo: ECuador President's Office)
President Lenin Moreno has right policies, but tied by dollarization,
BY WALTER T. MOLANO
The recent selloff in Ecuadorian bonds has been the most notable collateral damage produced by the Argentine debacle. Having missed the post-PASO collapse, the credit rating agencies tried to make up for their mistake by downgrading Ecuador’s sovereign debt rating—even though there had not been any recent developments and the next amortization was still years away. Two weeks ago, Moody’s downgraded Ecuador’s sovereign debt rating to Caa1 from B3. It was a classic move of locking the barn door, after the horse bolted. Ecuador has always been an accident waiting to happen. It is not that the government is doing anything wrong. On the contrary, it has been trying to pass key reforms to tamp down the fiscal deficit. Last year, it attempted to eliminate fuel subsidies. Unfortunately, this ignited a maelstrom of protests that forced the president to flee to Guayaquil. The problem with Ecuador is not political. It is economic.
Ecuador is the smallest member of OPEC. It joined in 1972, but, at times, it considered membership more of a burden than a benefit. In 1992, it voluntarily suspended membership, when it did not want to abide by the organizations’ attempt to boost oil prices by forcing production cuts on its member. It rejoined the organization in 2007, after the election of the anti-establishment President Rafael Correa. Although its oil exports are small in comparison to other OPEC nations, they total less than 400,000 barrels of oil per day; they are a large part of Ecuador’s total exports. Oil represents almost 60 percent of the nation’s total exports.
In 2000, the year when the government decided to dollarize its economy, one of the rationales for doing so was that, given that oil was its largest export and it is a commodity denominated in dollars, it would be natural to use that currency as its unit of exchange. However, dollarization was a grave mistake. It was useful in stabilizing the economy, after the enormous economic and financial volatility at the turn of the century. However, it significantly increased the economy’s vulnerability due to the inherent volatility of the oil markets. Using the analogy of a company, imagine if a company has tremendously volatile revenues. It needs to have an enormous capacity to manage its costs. Otherwise, sudden drops in revenues could force it out of business. The same goes for a country. If oil prices collapse, oil exporting countries need to rapidly reduce their costs. Otherwise, they will find themselves with huge trade and current accounts deficits and on the fast track to insolvency. The way most countries make the adjustment is through the use of floating exchange rate regimes. This allows the monetary authorities to devalue the currency, as soon as there is a downward move on oil prices. In effect, this is nothing more than giving a wage cut to all of the nation’s consumers and workers, in return producing a decline in imports. That way the country can continue to have its external accounts in balance.
Failure to have a floating exchange regime will leave the country with three options. The first option is to slash expenses. In reality, this would give all workers nominal wage cuts, which would push the economy into a recession. This is the option that the Ecuadorian government was trying to do with the fiscal reforms. The problem is that it is very unpopular, and it leads to social unrest. The second option is to create a national wealth or savings fund, which would save the bulk of the windfall produced by a rise in oil/commodity prices so that it can be deployed when prices collapse. The problem with this option is that it requires an enormous amount of discipline, something that most politicians are not known for having. The third option is to borrow the funds needed to close the external gap. This was another option Ecuador was employing. Unfortunately, investors grew wary of its deteriorating credit conditions. Moreover, when the Ecuadoreans turned to the IMF, it subordinated the existing bondholders, something that we learned when the IMF ran to Argentina’s rescue. Last of all, the good will expressed by Washington towards the new rightward leanings of President Lenin Moreno, may go up in smoke during next year’s presidential elections if former President Correa’s proxy comes to power. It would be a repeat of the Argentine post-PASO disaster.
So what is there to do? Ecuador needs to abandon its dollarization and move to a floating exchange rate regime. The IMF considers the real-effective exchange rate to be 32 percent overvalued, which means that, with a debt to GDP ratio of 35 percent and a 50 percent maxi devaluation, the debt to GDP ratio would jump to 70 percent. This would be devastating to the financial system, and it would need to be recapitalized. Therefore, Ecuador faces grave fundamental challenges that will not be easily or cheaply addressed.
Walter Molano is head of research at BCP Securities and the author of In the Land of Silver: 200 Years of Argentine Political-Economic Development.