Public Information Notice No. 03/47

Public Information Notice: IMF Concludes 2003 Article IV Consultation with Ecuador

April 7, 2003

On March 21, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Ecuador.¹

Background

Ecuador experienced severe economic stress in 1999, involving accelerating inflation, public debt default, and a currency and banking crisis. Following the adoption of the U.S. dollar as legal tender in January 2000, expectations stabilized, confidence returned to the banking system, and economic activity began to turn around. Demand was given further impetus by the start of the construction of a new oil pipeline, and escalating public sector spending.

However, economic growth slowed again in 2002 due to policy slippages and faltering confidence. Fiscal discipline weakened with large increases in the public wage bill, new revenue earmarking, and discretionary tax cuts. Moreover, oil output dropped because of inefficiencies in PetroEcuador; the structural reform agenda was suspended; and there was a high level corruption scandal in June. By the end of the year, the treasury was very short of cash and facing payment arrears. Nevertheless, in September, the Ecuadorian congress approved the Fiscal Responsibility and Transparency Law, which sets medium-term fiscal rules. This law could substantially lower the public debt and the country risk spreads, thereby crowding in investment and employment in the non-oil economy.

The government that took office on January 15, 2003 has taken bold measures aimed at strengthening the fiscal balance and helping to eliminate arrears. The new government's program also includes ambitious structural reforms to reduce rigidities in fiscal policy, resolve remaining problems with closed banks, and modernize the state enterprises. Completion of the oil pipeline will boost output growth over the medium term, and provide revenues that should provide the basis for a rapid reduction in public sector debt under the terms of the Fiscal Responsibility Law.

Executive Board Assessment

The Executive Directors commended the new government's quick and comprehensive actions to strengthen policies and address the challenges imposed by dollarization, while emphasizing the need for sustained implementation of the program.

While the economy had begun to recover following dollarization, Directors expressed concern that performance had not been sustained in 2002. Rapid public sector wage increases had undermined the fiscal position and contributed to excessive inflation for a dollarized economy, and to a further appreciation of the real effective exchange rate. Moreover, structural reforms had been suspended in key sectors, further jeopardizing competitiveness. Directors regretted the build up of large payments arrears to domestic and external creditors. Directors also expressed concern about institutional weaknesses that give rise to poor governance and corruption.

Under these circumstances, Directors considered that Ecuador faces major economic challenges. They, therefore, welcomed the bold measures taken swiftly by the new government after taking office on January 15. They commended the comprehensive nature of the authorities' program, which contains four main building blocks: immediate fiscal measures to boost revenues and control expenditures; fiscal structural reforms; liquidation of closed banks and other steps to resolve outstanding issues from the banking crisis; and reforms in the state enterprises. Directors also appreciated the authorities' efforts to build a social and political consensus for the program, and underscored that timely congressional approval of the reform laws is crucial. While recognizing that the program is ambitious, Directors called for its rigorous and timely implementation.

Directors agreed that the upfront fiscal measures are necessary in view of the immediate liquidity needs, and because expenditure growth needs to be brought back in line with the demands of dollarization. Given the substantial increases in the wage bill in recent years, Directors agreed that a wage freeze is essential for 2003. At the same time, Directors fully supported the authorities' steps to strengthen the social safety net to compensate the poor for the effects of some of the revenue measures. Directors encouraged the authorities to improve targeting ahead of the planned elimination of the cooking gas subsidy at mid-year.

Directors welcomed the plans to enhance the flexibility of fiscal policy by reforms in customs, civil service, and tax policy. These reforms are an integral part of the effort to limit the growth in public sector spending, maintain revenue buoyancy, and reduce revenue earmarking. Directors saw these reforms as necessary to establish a sustainable fiscal position over the medium term. Directors also strongly endorsed the authorities' efforts in setting up institutional and legal procedures to strengthen the foundation of fiscal policy. In particular, they welcomed the passage of the Fiscal Responsibility and Transparency Law, which creates a stabilization fund that provides a medium-term framework to substantially reduce Ecuador's debt and to protect the economy from external shocks. Many Directors expressed concern about the rapid growth in social security spending and urged the authorities to take precautionary steps to preserve the long-term solvency of the system.

Directors expressed concern about the pace at which outstanding issues left from the 1999 banking crisis were being resolved. In particular, the Deposit Guarantee Agency (AGD) has yet to collect on most of the loans held by the bankrupt banks, risking severe asset erosion, and Directors strongly supported the authorities' recent efforts to audit these banks and liquidate them. Directors also noted the poor functioning of the public sector development banks and urged their early and comprehensive reform. Directors looked forward to the results of the planned Financial Sector Assessment Program exercise.

Directors cautioned that, while Ecuador's medium-term growth potential is high, it can only be realized by sustained program implementation and strengthening competitiveness of the non-oil economy. The coming on stream of the new oil pipeline by end-2003 could alleviate pressures on the external current account, but it would be important to avoid crowding out the non-oil economy, and to cut debt levels rapidly. Therefore, Directors urged the authorities to adhere strictly to their fiscal reform and consolidation plan, and to press ahead with productivity-enhancing structural reforms, especially in the state enterprises. Such reforms would help strengthen competitiveness, and were seen as particularly crucial given the likely effects of real exchange rate appreciation and Dutch disease on the non-oil economy. Directors noted that, by strengthening savings and lowering the debt, Ecuador could reduce its risk profile and, thus, boost investment and employment in the non-oil economy. Directors also called for steps to improve governance, including reform of the politicized judicial system and strengthening of the rule of law, which would help improve the climate for domestic and foreign investment.

Directors considered that statistical information provided to the Fund is generally adequate, but urged the authorities to improve the timeliness of fiscal data and the accuracy of revenue and expenditure data to enhance the monitoring of economic developments.