Can’t pay or won’t pay?

Ecuador is in trouble again with its creditors. Arjen Thiescheffer examines the country’s payment history and looks at the prospects of avoiding another sovereign debt crisis.

Ecuador, the potential impact of its bond default on trade debt On 15 October 2006, Rafael Correa was elected the new president of Ecuador. In January 2007, the same day he was sworn in as Ecuador’s 56th president, he started signaling the possibility of a default on Ecuador’s foreign debt. It was, he said, “illegitimate”.

Following his inaugeration, the Ecudorian government setup an Investigation Commission and, subsequently, an Auditing Commission to examine the country’s debts. On 15 November 2008, the threat of default was finally carried out when Ecuador failed to make the coupon payment on its 12% 2012 global bond. Shortly after, Ecuador also defaulted on its 10% 2030 global bonds.

However, the impact of both the global recession and the lower oil price on the Ecuadorian economy and state budget were later cited as the real reason for the default. Consequently, Ecuador moved from a position of ‛won’t pay’ to a position of ‛can’t pay’.

Ecuador has a record of debt default going back to the mid-1980s when the country’s commercial banks defaulted. In this commentary, we will examine those past defaults, as well as the current economic and political environment, to enable us to better understand the potential impact of the payment default on the 2012 and 2030 global bonds on the remainder of the external debt obligations from Ecuador.

History of defaults by Ecuador
In February 2007, the Special Investigation Commission presented an analysis of Ecuador’s external debt from 1976 to 2006. This Commission was established by the government following concerns raised about the country’s high level of indebtedness.

The commission called for an international tribunal in charge of sovereign debt arbitration and the implementation of a special commission to audit all public debt, both internal and external, from Ecuador. As a result, the Audit Commission for Integrated Credit was established in July 2007.

But how did the external debt of Ecuador evolve and accumulate to its current size and characteristics? The first big event in the accumulation of Ecuadorian public debt was the purchase of a large amount of private debt by the government in the financial crisis of the early 1980s.

This caused public debt to soar from $1.7bn to $7.5bn and debt servicing to increase from 11.4% of the national budget in 1981 to 21.7% in 1982.

In 1987, Ecuador defaulted on its accumulated commercial bank debt, as did Brazil and other Latin American countries. After lengthy negotiations over eight years, the commercial (bank) debt of about $6bn in principal was restructured in 1995, as was the smaller Paris Club debt of $430m in 1994. The commercial debt was restructured via the issue of Brady bonds, which resulted in a haircut of about 40% of the face value of the bank loans.

However, this did not prove to be a lasting solution. Ecuador was hit by a major economic downturn just a couple of years later, as result of the damage caused by El Nino, falling oil prices and lower commodity prices. From 1997 to 2000, external debt peaked at 116% of GDP and debt service in the first quarter of 2000 was projected at about 66% of export revenue, forcing Ecuador to default on the coupon payments of the Brady bonds.

These Brady bonds, together with Eurobonds for an aggregate outstanding principal amount of $6.5bn, were exchanged for cash and the 2012 and 2030 global bonds, with a face value of $2.7bn in 2000. Next, a standby finance agreement with the International Monetary Fund (IMF) was set-up and a debt rescheduling agreement was arranged with the Paris Club bilateral creditors for $880m. After a 6% decline in GDP in 1999, Ecuador returned to a strong annual growth rate of about 5% for five consecutive years.

This growth and the low inflation during those years enabled Ecuador to attract a substantial amount of foreign capital from commercial investors again as it successfully tendered a bond issue of $650m (the 9.375% 2015 bond) in 2005.

One year later, Correa was elected president. His government made its intentions to reduce its external debt service very clear from the start. The share of external debt service from the state budget should be reduced from a high of 38% in 2006 to 11.8% in 2010. However, Correa has indicated that his preferred method of reducing debt service payments is by defaulting…

Current situation
The credit crisis, global economic downturn and the fall in the price of oil are all having a major deleterious effect on Ecuador’s economy. Foreign reserves have fallen by one-third to $3bn since the bond default and the current account surplus is rapidly turning into a deficit (the IMF is forecasting a deficit of 3.5% of GDP in 2009). In April 2009, Ecuador had to turn to the Latin American Reserve Fund to finance its balance of payments via a loan of $480m.

The current account deficit is not only a result of the lower oil prices, but also from the capital outflow as a result of the rise of Ecuadorian political risk. Correa has vowed to spend as much money as possible from the state budget directly for the benefit of the inhabitants of Ecuador and as little as possible for external partners. However, the measures taken accordingly, including the bond default, have generated uncertainty among investors and economic growth has suffered.

Bond default and buy-back offer
The bond default occurred in November 2008. Shortly after, Ecuador hinted that it would offer a buyback of the outstanding bonds on which it defaulted in a bid to avoid a similar situation as Argentina, with potentially lengthy litigation and isolation from the global capital markets.

On 20 April 2009, Ecuador launched a cash buy-back tender by way of a modified Dutch auction. A modified Dutch auction enables bondholders to indicate how many bonds and at what price within a buyer’s specified range they wish to tender. All bonds purchased in the tender offer will be purchased at the same determined price per bond regardless of whether the bondholder tendered at a lower price. Ecuador had set the minimum price at 30%, which is the average price in 2009.

Most likely, not all investors will tender their bonds – some will hold out, hoping for better times and a more investor-friendly government, and some will push for litigation and seek repayment via the seizure of Ecuadorian assets in foreign jurisdictions. In anticipation of this, the government has already taken steps to protect sovereign assets from eventual court rulings favouring holdouts.

The latest news is that the buy-back offer on its commercial debt is heading for success. The Ministry of Finance indicated that more than three-quarters of the outstanding bonds have been offered by the bondholders at 35% of face value.

Ecuador’s economy in figures

	2006	2007	2008
Nominal GDP	$43.5bn	$45bn	$51bn
State budget			$15bn
GDP per capita	$7,100	$7,200	$7,500
Inflation	3.3%	2.3%	8,4%
Current account (% of GDP)	3.9%	3.7%	2,3%
Reserves	$2bn	$3.5bn	$4.5bn
Fiscal balance (% of GDP)	3.7%	1.8%	3.2%
External debt	$18bn	$17.7bn	$17bn
- public	$11bn	$10.5bn	$10.3bn
- multilateral	$4.4bn	$4.7bn	not available
- bilateral	$2bn	$1.7bn	not available
- commercial	$4.15bn	$4.1bn	not available
- suppliers	not available	$69m	not available
- private	not available	$6.9bn	not available
External debt (% of GDP)	41.4%	39.2%	19.2%
Key exports		Oil (57%), fruit (13%) and fish (8%)
Credit ratings	Fitch	CCC-
	Moody’s	CAA1
	Standard and Poor’s	SD

Audit of Ecuador’s public debt
The default on the 2012 and 2030 bonds was mainly a result of the findings of the auditing committee, the Special Audit Commission, which was set-up in July 2007. This committee has analysed and audited all current public debt from Ecuador, both internal and external. The juridical analysis of some of the multilateral and bilateral credits resulted in a conclusion that some of the contracts are “hateful, illegitimate and illicit”. Bilateral agreements with three countries – Spain, Brazil and Japan – were specifically cited.

Ecuador’s debts can be broken down into four categories. The multilateral credits were mainly received from the World Bank ($700m outstanding), the Inter-American Development Bank ($2bn outstanding) and the Andean Development Cooperation (CAF, $1.9bn outstanding) – all figures as of 31 December 2007.

The largest bilateral creditors are Belgium, Brazil, China, Denmark, the United Kingdom, France, Germany, Italy, Japan and Spain. Of these creditors, the largest was Brazil, with an outstanding balance of about $550m, followed by Spain with about $375m.

The balance of the Paris Club debt was about $840m, with the largest creditors being Italy (30%), Israel (19%), Japan (12%), France (12%) and the UK (11%). The projected payments to Paris Club creditors until 2023 are about $1.1bn, including interest and other costs. Commercial credit mainly consists of bond issues – among others, the heavily criticised global 2012 and 2030 bonds on which Ecuador defaulted.

Macro-economic developments from 2006-2008 in Ecuador As can be seen in table one, which outlines the key economic indicators, Ecuador’s GDP has continued growing since 2006. Indeed it registered a rise of almost 15% in 2008, mainly as a result of the spike in oil prices and other commodities. However, inflation also showed a sharp increase after years of steady price increases. After a peak of foreign currency reserves for an amount of about $6bn in October 2008, the capital outflow and the lower oil prices caused the foreign reserves to move down to $4.5bn at the end of 2008.

Political developments
Correa won re-election for a second term in April 2009 by a large margin over his nearest rival. His party also won a legislative majority. That vote followed a referendum in September 2008 in favour of a new constitution increasing the power of the president and state.

Once the constitution is implemented, Correa will have extensive monetary and financial authority and will be able to dissolve congress, while most international arbitrations on disputes will be restricted and the state will have the right to confiscate certain farm land.

So, his re-election in April 2009 strengthens the current government in its populist approach, even though the consequent uncertainty for business has damaged private investment and economic development.

Implications of the bond default and the macro-economic and political developments for holders of (defaulted) trade claims on Ecuador

The plunge in the price of oil, from $147/barrel to below $40 in the space of six months, the sharp fall in the price of other commodities and the capital flight from emerging markets all ought to have had a profound impact on the state budget and, hence, Ecuador’s ability to make debt service payments.

At first glance, all these indicators point to a default similar to Ecuador’s last major default in 2000. However, a closer look at these figures suggests a more positive outcome. First of all, despite the collapse in oil prices, the current levels of about $60-$70/barrel is almost a triple the price of 1998-2000.

The main difference is that government spending has increased considerably since 2000 and the constant rise in oil prices since 2003 have consequently made Ecuador more dependent on oil for its prosperity. In 2009, the government’s budget is $17bn. Barclays has estimated that Ecuador requires an oil price of $95 to cover all its spending and $76 to avoid depleting reserves.

The second comparison that can be made is the share of the state budget of debt-service payments. In 2000, the external public-debt service ratio was about 29%, while today it has declined to 12%. The total external debt in 2000 was about $13.2bn, with a GDP of $13.6bn. At the end of 2008, the external debt was about $10.3 with a GDP of $51bn.

The third indicator, the net-capital outflow, does seem more in line with the crisis years of 1998-2000, when the Asian financial crisis prompted a sharp decline in net capital inflows. However, because the current crisis seems to be more severe, global and originated in the developed economies, the impact on the availability of capital for political-risk countries, such as Ecuador, seems to be harder and longer.

After its default in 2000, Ecuador capitalised on the rally in oil prices, global economic growth, the easier availability of capital and the risk appetite from private investors. This enabled it to enter the private capital market as early as 2005 with the 2015 9.375% bond. In today’s risk-aversive world, and taking into account political developments in Ecuador and across the region, it might take much longer before investors are willing to re-invest in Ecuador again.

Finally, it is worth noting that the inflation rate in Ecuador was 96% in 2000. By 2008, this had fallen to 8.4%, with the IMF expecting it to fall further to about 4% in 2009. This comparison of indicators does not immediately justify a major debt default for Ecuador. Still, the dependence of Ecuador on the high oil prices of recent years, current capital outflows and the focus by the government on public spending over its obligations to external creditors, entail a risk in the short and medium terms that Ecuador will be ‘forced’ to restructure its external debt.

Also, Ecuador has committed to forgo the development of the country’s largest oil reserve, the Ishpingo Tambococha Tiputini (ITT) field, located below Yasuni National Park, the Amazon basin’s most biodiverse area of rainforest. In exchange for forgoing an estimated $9bn in oil revenues, it has asked the international community for compensation through, among others, debt relief. Such debt relief is still under consideration and negotiation with different multilateral and bilateral creditors.

Can’t or won’t pay?
In conclusion, we can say that the recent debt default seems politically motivated and a result of an unwillingness to pay rather than an inability to pay. With the indication that the buyback offer is successful, it is likely that Ecuador will seek a comparable level of debt restructuring – that is to say, a net present value of about 30% – of some of its multilateral debt, mainly with the World Bank, and its bilateral debt, especially agreements with Spain, Brazil and Japan.

Paris Club creditors will expect Ecuador to seek a comparable debt treatment with the remaining commercial and suppliers/trade debt. Also, the apparent success of the current buyback of bonds could motivate the government to offer a similar buyback proposal for the remaining outstanding 2015 and Brady bonds (about $766m). Naturally, this mainly depends on the help of regional lenders.

The absence of sufficient funds to service debt, due to a deteriorating economic environment and the relocation of funds to local expenditures, could further alter the motivation from Ecuador for a debt restructuring of a large part of its external public debt from unwillingness to inability. The willingness of multilateral and bilateral creditors to agree on a debt restructuring will depend on such a change of reason and their willingness to aid Ecuador in the current global crisis.

In the end, Ecuador’s private sector will likely bear the brunt of Ecuador’s decision to default on its commercial public debt and potentially seek a debt restructuring for a part of its remaining external public debt. Access to credit and trade finance might dry up and supply chains may be disrupted. With private debt at about $7bn in 2007, and the consequences of the developments in the public external debt, the risk of a default in the private sector from Ecuador seems larger than a default in the public sector.

A.R. Thiescheffer
thiescheffer@omnibridgeway.com
+31 70 3384343