After the Honeymoon

He argued strongly for dollarization: now Carlos Julio Emanuel must act quickly to take advantage of it. Brought into government as economy and finance minister last October, Emanuel’s task is to keep national accounts in the black while helping to devise policies that will enable Ecuadorian companies to compete in the harsh new environment of enforced fiscal discipline.

“Everything has become much more transparent since dollarization,” he says. “Companies can’t hide their inefficiencies. Our top priority now is to help improve competitiveness. We have to attack the costo Ecuador.”

That means rooting out inefficiencies in government as much as in the private sector. Dollarization may have given the government the room it needs to get this done. Last year’s economic growth of 5.4% will be followed by 4% this year, according to the Central Bank. Inflation will fall from 91% last year to 22%. Funds are slowly but surely returning to the banking system, and both investment and consumer spending – especially on big ticket items like construction and cars – are firmly on the up. Remittances from Ecuadorians living abroad are likely to reach $1.5 billion this year, after $1.4 billion last year, making them the second biggest source of foreign income after oil.

But while the rate of growth is impressive, much of it is recovery from the slump of 1999, when the economy contracted by 7.3%, after growing by 3.4% in 1997. True, growth in the years prior to the slump was clearly unsustainable, as it was based on unmanageable fiscal and current account deficits. With the discipline enforced by dollarization, growth must now be based on sound fiscal policies. Already, some sectors of the economy are doing better than they were in 1997 and 1998. But growth is uneven. Many businesses must battle against red tape and corruption and lack the confidence to invest. The government’s challenge is to change that while it still has healthy economic growth on its side.

One priority is tax reform. The tax system is riddled with specific taxes for specific projects. Value added tax on telephone bills, for example, is earmarked for spending on water services and sports. If a new port terminal is needed, a new tax is introduced to pay for it. Such earmarking ties the government’s hands and restricts its ability to respond to shocks. Emanuel hopes a tax reform bill – designed to simplify the system without reducing overall tax revenues – will go to Congress during the first quarter.

Leaving aside the difficulty of getting such changes through a fragmented Congress during an election year, enacting structural reform requires a delicate balancing act. Last year was a good one for Ecuador’s fiscal accounts. The non-financial public sector showed a surplus of 0.6% of GDP, outperforming the government’s prediction of a deficit of 0.25% of GDP. Faster than expected economic growth and improvements in tax collection helped the tax take rise to 14% of GDP, up from 12.2% in 2000, according to the Central Bank. The government made an overdue payment of $55 million to the Paris Club and sent a fiscal reform bill to Congress, satisfying conditions for the release of loans from the IMF and opening the door to negotiations on a new IMF-led loan package, now underway.

But last year’s primary fiscal surplus was far outweighed by a current account deficit of 5% of GDP, caused mostly by falling global oil prices and reduced earnings from important export crops like bananas and shrimp. While it is likely that Ecuador’s financing needs will be covered by more support from the IMF this year, the Fund has made it clear that it wants the government to do more to close the fiscal gap.

How much tightening is needed won’t become clear until the end of negotiations with the IMF, although Emanuel expects a loan package to be announced in April. But there is little doubt that the government’s budget will have to be squeezed. According to Multiplica, a Quito consultancy, overseas interest payments of $724 million and amortizations of $777 million will contribute to a current account deficit in 2002 of $1.7 billion, or more than 8% of GDP.

Savings In Other Areas
Where will the money come from? Two revenue-raising measures were thwarted last year when they were thrown out by the Constitutional Tribunal, which issues rulings on the constitutionality of legislation. First to go was an increase in the rate of value added tax from 12% to 14%. (Despite the ruling, receipts from VAT rose strongly during 2001, but this was caused largely by inflation; as inflation continues to fall, so too will VAT receipts.) The other blow came when the Tribunal questioned the legality of privatizing Ecuador’s electricity distribution network. The sale had been due to take place last October but had to be postponed because of the ruling; Emanuel is adamant that it will go ahead during the first quarter, and wants to see the Constitutional Tribunal’s power reined in. “Things could be better along those lines,” he says. “We need to be able to depend on the rule of law. The President’s political reform bill will include judicial reform.”

Meanwhile, the government is looking for savings in other areas. A proposal to end a subsidy on cooking gas, which costs the government about $150 million a year, was scratched after violent popular protest in January. Emanuel hopes to scrap just part of the subsidy, targeting the remainder on the poor, by March or April. If successful, the move would save about $100 million a year, though savings during the rest of 2002 would be at most $75 million.

An innovative option being studied is the securitization of oil revenues. Revenues from oil have fallen with international prices, but when the new pipeline comes on stream in mid-2003, Ecuador’s production capacity will double. That will provide enormous relief to the current account. Emanuel hopes that securitization will make revenue available before the oil starts flowing, although plans are still in the early stages.

The other area where cuts may be made is in capital spending. The government has budgeted for about $1.4 billion in capital spending during 2002, almost double the amount in 2000. As the government typically falls short on capital spending each year as projects are delayed for administrative and other reasons, savings here should be possible.

But the biggest question mark over the government’s budget is the price of oil. The budget for 2002 has been prepared on the assumption of an average international oil price of $19 a barrel during the year. Most analysts agree that that is an optimistic forecast. (Venezuela, another country whose economy is highly dependant on oil exports, has based its projections on an average price of $16 a barrel.) And as Emanuel points out, every dollar off the average price per barrel cuts more than $60 million from government revenues. But here, too, there may be room for maneuver. The government prefers to shoot high rather than low on the oil price, as any oil revenues in excess of expectations are earmarked in advance.

In another attempt to reduce the effects of earmarking, the government has sent a bill to Congress that would create a fiscal stabilization fund, designed to give it more freedom in responding to external and domestic shocks. Capital for the fund would come from royalties generated by the new oil pipeline: 80% of royalties would go to the fund, and the remaining 20% to repurchase or pay off government debt. Emanuel says the bill has “fairly good” prospects of being approved, but adds that if Congress resists, the bill will be sped along using fast track or possibly veto powers to get it through.

More fundamental reforms may be harder to push through. To achieve greater efficiency Ecuador needs a more flexible labor market. An important move in this direction would be to repeal legislation forcing companies to share out 15% of pre-tax profits among employees. Mr. Emanuel would like to see this done, but admits that the political cost would be too great. Another option would be to increase the flexibility of Ecuador’s labor code, but proposals for this have yet to be drawn up.

A Return to Investment
The collapse of the financial system from 1999 brought capital markets to a virtual standstill. Although activity on the stock market remains close to zero, there have been some debt issues on local markets. Banks are gradually building deposits as Ecuadorians slowly recover some confidence in the banking system. Interest rates remain high, but the stable outlook brought by dollarization has prompted a return to investment, most of it financed by bank lending. Reform of the sector includes forcing banks to comply with Basle capital requirements. Many of Ecuador’s private banks already do so.

For the foreseeable future, however, overseas capital markets remain firmly closed to Ecuadorian borrowers. That won’t change until Ecuador’s sovereign risk is reduced through continuing reform and modernization of the economy. While the current boom lasts, the government must seize its moment.