Public Information Notice No. 04/91

Public Information Notice: IMF Concludes 2004 Article IV Consultation with Ecuador

August 12, 2004

On July 26, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Ecuador.¹

Background

Ecuador's macroeconomic performance over the past year has been generally positive, aided by a favorable external environment, the completion of the new oil pipeline, and the implementation of the new Fiscal Responsibility and Transparency Law. The opening up of the new pipeline in October 2003 has boosted oil production by private companies by almost one half. As a result, overall real GDP grew by 2.7 percent in 2003 and 5.9 percent in the first quarter of 2004, even as non-oil GDP growth slowed to below 2 percent. Inflation has continued to decline, falling below 3 percent in June 2004.

The external current account deficit declined sharply in 2003, reflecting high international oil and commodity prices, a reduction in the real effective exchange rate related to the depreciation of the U.S. dollar, and the end of imports related to construction of the pipeline. Oil and non-oil exports grew by 27 percent and 14 percent, respectively, while imports increased by 1 percent. In the capital account, foreign direct investment increased to just under 6 percent of GDP reflecting mainly pipeline-related investments. However, net capital flows to the public sector remain negative, mainly on account of amortizing debt to official creditors and continued lack of access to international credit markets.

Financial intermediation increased significantly in the 12 months ended May 2004. Deposits and credit to the private sector increased by 20 percent and 14 percent, respectively. The fastest growing segments of the lending market in the last six months have been housing and microenterprise lending, albeit from a very low base. Nonperforming loans as a proportion of total loans decreased between end-2002 and April 2004. Domestic lending rates declined by 150 basis points to 10 percent during the year ended May 2004.

High oil prices and restraint by the central government on nonwage spending helped improve fiscal performance in 2003. The primary surplus of the nonfinancial sector (NFPS) rose to 4.7 percent of GDP in 2003, compared with 4.5 percent in 2002. At the same time, however, the non-oil primary deficit rose from 1.2 percent of GDP in 2002 to 1.4 percent of GDP. Real primary expenditure of the central government fell by 5 percent in relation to 2002, reflecting declines in both capital and nonwage current spending, but such spending increased by 14 percent in the rest of the NFPS, including a real increase in pension benefits of over 50 percent. Helped by a doubling of lending by multilateral agencies, the government was able to clear external arrears and reduce its large stock of domestic payments arrears.

The central government experienced liquidity problems in the first half of 2004, including an accumulation of domestic nondebt arrears. The liquidity problems are related to the structural cash flow problem faced by the central government arising from the large earmarking of revenues and subsidies, which amount to almost 11 percent of GDP, or about 60 percent of gross central government revenue. The problem has been exacerbated by the reallocation of oil revenues to the oil stabilization fund (FEIREP) that previously accrued to the central government (equivalent to 1.2 percent of GDP). In April, the authorities implemented measures to ease the cash flow problem and to achieve a primary surplus target of around 5 percent of GDP for the NFPS. They announced spending cuts at the central government level of about US$150 million and a plan to use the 20 percent of the FEIREP assets reserved for emergencies for financing in 2004. However, in July, a decision to increase pension benefits by about ½ percent of GDP has made the attainment of the fiscal target more difficult.

Progress on the structural agenda has been mixed. In the fiscal area, new customs legislation approved by congress created a stronger and more effective board of directors but failed to exclude customs workers from the civil service, which has made it difficult to carry out much needed personnel changes. A civil service reform that was implemented this year has brought more clarity to the wage structure and made it more coherent but has put upward pressure on the wage bill.

On public enterprise reform, attempts to auction rights for increased private sector participation in specific PetroEcuador oil fields failed in the absence of a new hydrocarbons law to provide a clear and adequate legal framework. In the electricity and telecommunication sectors, efforts to introduce private sector management to the sectors have made little progress for a similar reason.

In the financial sector, the authorities sent to liquidation five of 18 closed financial institutions. However, among those left are two of the largest banks, with deposits of more than US$70 million still to be returned to depositors. The process of bringing Banco del Pacifico, the only remaining publicly-owned commercial bank, to the point of sale has been delayed.

Executive Board Assessment

Directors welcomed indications that growth is accelerating, particularly in the oil sector, inflation is declining, confidence in the financial sector is broadening, and fiscal performance is strengthening, aided by higher international oil prices and export volumes and the ongoing global recovery. At the same time, Directors noted that important challenges remain to reduce existing vulnerabilities in the context of a dollarized economy and to raise long-run growth potential, particularly in the non-oil sector. They called on the authorities to take the opportunity presented by the current favorable external environment to accelerate the implementation of reforms to address the economy's persistent structural weaknesses, in particular in the fiscal accounts, financial sector, and the public enterprises.

Directors concurred with the authorities' plans to run substantial primary surpluses in the nonfinancial public sector, which will bring down the public debt-to-GDP ratio and help Ecuador regain access to international capital markets. They noted that the adoption of the Fiscal Responsibility and Transparency Law (FRL) and the FEIREP oil stabilization fund provided a framework for controlling expenditure and reducing the non-oil deficit and overall debt. Pressures to weaken the FRL should be resisted, and resources in the FEIREP should begin to be used for external debt buybacks, as intended.

Directors expressed concern about the ongoing cash flow problems in the central government, which seemed to have contributed to further increases in domestic arrears. They stressed the importance of controlling spending on pensions and public sector wages, both of which had increased rapidly in recent years.

Directors commended the authorities' intention to present a 2005 budget fully compliant with the FRL. Successful implementation of such a budget will be crucial to reduce the stock of domestic payments arrears, increase transparency about spending in the public sector, and build confidence in the authorities' ability to sustain prudent fiscal policies. Directors emphasized the need to further strengthen the fiscal policy framework over the medium term. They welcomed the authorities' initiatives to upgrade their public expenditure management, including plans to implement the recent fiscal Report on the Observance of Standards and Codes (ROSC) recommendations. They urged the authorities to phase out widespread revenue earmarking, reduce tax exemptions and central government subsidies to the social security system, and take measures to place the pension system on an actuarially sound basis. Poorly targeted subsidies for oil derivatives should be replaced with better-focused poverty reduction measures. It will also be crucial to implement the planned public sector wage realignment in a prudent way, and to develop a coherent civil service reform strategy.

Directors recommended that, to support economic diversification and private sector employment growth, the authorities take further actions over the medium term to improve the business climate. These should include, in particular, strengthening the legal system and the rule of law, resolving conflicts in regulations, fighting corruption, and laying the basis for a more efficient financial system.

Directors called for the authorities to make faster progress in strengthening the performance of the public enterprises. The authorities were encouraged to persevere with their plans to modernize and restructure PetroEcuador, and to liberalize the domestic petroleum derivatives markets. Directors supported the authorities' efforts to implement a new legal framework to increase private sector participation in the oil sector. They stressed the need for reforms in the electricity sector, to reduce costs and to attract much-needed private investment to increase capacity. Toward this end, the electricity tariff-setting framework should be depoliticized, stronger sanctions should be imposed on delinquent customers, and the cross-debts in the sector should be resolved. Directors were encouraged by the growing confidence in the financial sector, as shown by increased intermediation through the banking system, and commended the authorities' intention to follow up on the recommendations of the recently completed Financial Sector Assessment Program (FSAP). They observed that enforcement of creditor rights and enhanced corporate sector transparency could encourage more lending by banks, and help lower the current high interest rates on loans. Directors urged the authorities to move expeditiously to complete the process of liquidating closed banks. They welcomed the authorities' plans to lower the real estate transfer tax, which would facilitate the sale of assets of closed banks by the Deposit Guarantee Agency, and speed up the removal of the deposit freeze in these banks.

Directors considered that preserving competitiveness in a dollarized economy such as Ecuador's will continue to present the authorities with policy challenges. They urged the authorities to implement fiscal and structural reforms that would help control costs and invigorate the non-oil economy. They welcomed the authorities' efforts to negotiate a free trade agreement with the United States, and encouraged them to participate in the multilateral trade liberalization process.

Directors recognized the political difficulties facing the authorities in advancing reforms, but encouraged them to prioritize the reforms and persevere with them. Indications that the government was galvanizing support for its reform agenda across Ecuadoran society, and thereby strengthening the likelihood of its success, could lay the groundwork for closer collaboration with the international financial institutions.

Directors noted that Ecuador has subscribed to the Special Data Dissemination Standard (SDDS), but its statistical base still needs improvement. They urged the authorities to address shortcomings in the quarterly national accounts and the nonfinancial public sector data in order to enhance the ability to monitor policy effectiveness.