Public Information Notice: IMF Concludes Article IV Consultation with Ecuador
September 7, 2000
|Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.|
On August 28, 2000, the Executive Board concluded the Article IV consultation with Ecuador.1
After several years of weak macroeconomic performance, a major economic and financial crisis engulfed Ecuador in 1999. The main contributory factors were: failure to deal in a timely manner with emerging weaknesses in the banking system; a series of external shocks, including the decline in world oil prices and the turbulence in financial markets following the 1997–98 Asian crisis and the El Niño weather phenomenon; policy weaknesses, including public sector deficits and an expansionary monetary policy. The effects of these factors were exacerbated by lack of progress in structural reform.
Real GDP grew by about 2½ percent a year during 1993–97, stagnated in 1998 and fell by about 8 percent in 1999. The 12-month inflation in consumer prices averaged 31 percent a year in 1994–98, and accelerated to 52 percent by 1999. The external current account deficit widened to 11 percent of GDP in 1998, as both oil and nontraditional exports fell, and imports rose strongly. In 1999, private capital outflows forced a drastic adjustment of the external current account balance to a surplus of 7 percent of GDP, with imports contracting by 46 percent (in U.S. dollar terms).
The combined public sector deficit widened from about 2½ percent of GDP a year in 1995–97 to 6 percent of GDP in 1998, and further to 7 percent of GDP in 1999. Initially, the deterioration reflected declining world oil prices, and expenditure increases, including on wages. In 1999 a sharp increase in the interest bill following the large depreciation of the sucre and the carrying cost of government bonds issued in connection with the banking crisis, and increased subsidies on domestic fuels, outweighed the revenue gains from the recovery in oil export prices. Because of fiscal pressures, the government stopped payments on Brady bond obligations in September 1999 and defaulted on its Eurobond obligations one month later.
Monetary and exchange rate policies were undermined by the banking crisis. Reflecting efforts to support the banking system, the growth of the monetary base increased to 136 percent in 1999, compared to an average of 34 percent during 1995–97. There were repeated episodes of exchange market pressures, with the exchange rate intervention band being devalued twice in 1998, before the sucre was allowed to float in February 1999. The sucre depreciated against the U.S. dollar by 54 percent during 1998, 200 percent during 1999, and by a further 25 percent in the first week of 2000. In real effective terms, the exchange rate depreciated by about 47 percent from December 1997 to January 2000.
The banking system was weakened because of inadequate supervision, connected lending practices, and high exposure to currency risk. Serious solvency problems started to emerge in early 1998, but lack of an adequate legal framework for intervention delayed action until December 1998, when the government created a deposit insurance agency and announced a comprehensive deposit guarantee. However, doubts about the government’s fiscal ability to honor the guarantee led to a run on deposits in March 1999, forcing the authorities to declare a one week bank holiday and to freeze bank deposits. Bank credit to the private sector, which had slowed in 1998, fell by 27 percent in nominal terms in 1999. Eventually, 16 financial institutions, accounting for about 65 percent of the system’s onshore assets, were intervened or closed. In August 1999, the authorities began to unfreeze demand and savings deposits, with an estimated one-third of the freed deposits going into capital flight.
The government economic program for 2000 seeks to restore confidence in economic management, stem the decline in economic activity, and lay the basis for economic recovery. These objectives are to be achieved through the dollarization of the economy (the legal basis for which was provided by the Ley Fundamental para la Transformación Económica approved by the congress on March 9, 2000), a significant fiscal tightening, implementing a comprehensive bank restructuring strategy, and introducing a series of wide-ranging structural reforms aimed at making the labor market more flexible and increasing private sector participation in the economy. The program has been supported with financial resources from the international financial institutions, including an IMF Stand-By Arrangement approved on April 19, 2000.
Developments under the program have been encouraging. Economic conditions appear to have stabilized and there are signs of a gradual recovery in economic activity. Inflation remains high (the 12-month rate reached 102 percent in July), however, mainly reflecting the pass-through of the large depreciation of the sucre prior to dollarization and increases in domestic fuel prices introduced in May, 2000. Dollarization, which has proceeded rapidly, has calmed the financial markets and there has been a significant improvement in bank liquidity, notwithstanding the unfreezing of time deposits from March 2000.
On August 23, 2000 a debt exchange for Ecuador’s Brady and Eurobonds was finalized. The exchange resulted in a debt reduction of about 40 percent, and should allow Ecuador to achieve fiscal and external sustainability over the medium term provided the appropriate supporting policies are in place.
Executive Board Assessment
Directors welcomed the improved economic performance in the first half of the year: the fiscal and external positions are stronger, and the banking system more liquid, than anticipated. Moreover, the dollarization of the economy is proceeding rapidly and there are indications of some recovery in economic activity. Directors saw this performance, combined with the successful debt exchange earlier this month, as indicative of a gradual return of confidence in the Ecuadoran economy and the beginnings of a reversal of the effects of several years of policy weakness and poor performance. They considered that the risks to achieving the authorities’ objectives—while still substantial—have diminished over the past few months. Nevertheless, Directors noted the fragility of the current situation, as well as the contribution that higher world oil prices had made to the recent improvement. Against this background, they emphasized the need for broad and durable consensus to sustain the hard-won gains of the past few months, notably to keep the fiscal deficit low, create a more robust financial system, and deepen the structural reform process.
A weak fiscal policy, with growing fiscal deficits, high tax revenue earmarking, and revenues overly dependent on oil prices, had been important in undermining macroeconomic performance in the 1990s. Directors therefore particularly welcomed the fiscal adjustment this year, including through the reduction in domestic fuel price subsidies in May. They emphasized the need for a tight fiscal stance for the foreseeable future, with substantial primary surpluses and lower overall deficits to support dollarization in the near term, and to achieve a sustainable fiscal and external position over the medium term. This would require a comprehensive tax reform to increase non-oil tax revenues and to reduce the earmarking of tax revenues. The expected revenue loss from the elimination of some taxes and duties would need to be compensated by a broadening of the tax base, changes in the tax rates for the VAT and income tax, and the introduction of excises on domestic fuel. These measures would need to be included in the budget proposal for next year.
Directors noted that fiscal consolidation would take place in an environment of substantial demands on public expenditures arising from the urgent need to improve the social safety net—in part to protect living standards of vulnerable groups during the process of restructuring. Moreover, the authorities need to reverse the deterioration in social indicators, and repair and improve public infrastructure. Given the fiscal constraints, Directors encouraged the authorities to further reduce subsidies on domestic fuels and maintain tight control over expenditures. They urged the authorities to give high priority to improving the targeting of public expenditures and to strengthening the capacity to implement capital projects. Directors welcomed the current reform proposal for the pension system which should move the system to a sounder financial footing and reduce its drain on the public finances. Directors also urged the authorities to move quickly to eliminate domestic payments arrears.
Directors were encouraged by progress in strengthening and restructuring the financial sector, in particular the schemes to recycle bank liquidity, develop a liquidity stabilization fund, and provide for a voluntary restructuring of the large debts to banks of households and enterprises. They encouraged the authorities to move forward with greater speed and determination in implementing the banking strategy so as to create a financial system that was efficient, competitive, adequately capitalized, and able to intermediate financial resources effectively in a dollarized economy. Directors noted that delays and inadequate measures already had added significantly to the fiscal cost of the banking crisis. They welcomed the greater interest rate flexibility implicit in the new calculation for the usury interest rate ceiling, but urged early removal of the ceiling and of the restrictions on bank fees.
The process of structural reform, which had moved forward with the two trolleybus laws approved in March and August of this year, was seen by Directors as vital to improving a lagging productivity performance and laying the basis for long-term sustained growth. The laws paved the way for a more flexible labor market, the privatization of key industries, and increased private sector participation in the oil sector. Directors encouraged the authorities to move ahead aggressively on the privatization front while proceeding, at the same time, with complementary measures to improve the working of the labor market. Some Directors also noted that early steps toward a more liberal trade regime would complement other structural reforms.
Directors noted that the authorities had made significant efforts to normalize relations with private sector external creditors, leading to the successful conclusion of the debt exchange on August 23. They urged them to reach agreement with Paris Club creditors at the September meeting, and to conclude negotiations with foreign banks to stabilize and rebuild their trade credit lines and related exposure to Ecuador. This would enable the financing gaps to be closed in the near term, and make a substantial contribution toward a more sustainable fiscal and external position in the medium term.