US embassy cable - 05QUITO289

UNCLAS SECTION 01 OF 04 QUITO 000289 
 
SIPDIS 
 
DEPT FOR WHA/AND 
DEPT FOR WHA/PD LEBENS 
DEPT PASS USTR FOR BENNETT HARMAN 
DEPT PASS USAID LAC 
 
E.O. 12985: N/A 
TAGS: ECON, ETRD, ENRG, EAID, PGOV, EC, Economy 
SUBJECT: ECUADOR'S ECONOMY: DOING WELL FOR THE WRONG REASONS 
 
 
1.   Summary:  Despite chronic political instability, 
Ecuador's economy continues to hum along to the tune of high 
oil prices, increased oil exports, dollarization (and the 
resultant stability and low inflation), and responsible 
fiscal policies.  In 2004 the GOE paid down its 
international debt and all economic indicators are looking 
good.  Prognostications for 2005 are also positive.  The IMF 
has issued a positive "assessment" letter on the GOE's 
management of the economy and established an enhanced 
surveillance program with the government, opening the door 
to increased lending by international financial institutions 
(from a low point in 2004).  The GOE is planning further 
attempts to enter financial markets and manage their 
international debt.  The cherry on top is the FTA.  However, 
much depends on the GOE's success keeping political poison 
from infecting the economic sphere.  And the cloud adorned 
by all these silver linings is Ecuador's continuing 
inability to carry out the crucial reforms needed for long- 
term economic stability and growth.  See paragraphs 14-22 
for our plans to push forward U.S. economic and commercial 
interests in the short, medium and long term.  End Summary. 
 
2004: The Year of Opportunity 
----------------------------- 
 
2.   A banking contact of ours recently concluded that, as a 
result of dollarization and responsible economic management, 
"Ecuador has seen the last of street mobs calling for the 
overthrow of the President."  We're not ready to go that 
far, but our friend makes an important and oft-overlooked 
point about the current situation here:  despite all the 
sound and fury of the repeated political crises, the 
Gutierrez government has been one of the most economically 
responsible governments of recent Ecuadorian history, and 
the 2004 results, a combination of dumb luck and smart 
policy, have been nothing short of spectacular.  Economic 
growth was about 6.5%, inflation dropped below 2%, and the 
government paid back a net $400 million in international 
debt, bringing its debt to GDP ratio to under 40% (down from 
about 90% in 1999). 
 
Dumb, and Not So Dumb, Luck 
-------------------------- 
 
3.   The price of oil is certainly the most obvious piece of 
good luck Ecuador benefited from in 2004.  Although 
Ecuadorians have been disappointed to see the price for 
Ecuador's heavy crude fall further behind that of lighter 
crude with every price peak they reached, Ecuador has 
benefited from a substantial windfall 1 from the increase of 
prices over their 2003 level.  The effect of the windfall 
was particularly great as it coincided with an expansion of 
over 50% in oil exports by private companies in the 
aftermath of completion of the heavy crude pipeline (OCP for 
its Spanish acronym) in late 2003.  However, state-owned 
Petroecuador struggled just to maintain oil production in 
the short term, after a decade of decline. 
 
4.   With oil money sloshing into the country, the question 
on many people's minds became how to use it.  Public sector 
workers went on strike; pensioners went on strike; teachers 
went on strike; each seeking to share in the wealth. 
Shielding themselves behind the fiscal responsibility law, 
which limits increases in budgets and segregates oil 
revenues from other revenues, dedicating them mostly to 
payment of public debt, two responsible Ministers of Finance 
held the line (mostly).  The pressure eventually became too 
intense for Mauricio Pozo, who resigned at mid-year to be 
replaced by Mauricio Yepez, the former President of the 
Central Bank.  Both Mauricios applied a policy of under 
executing the budget, and thus keeping it within the limits 
set by the Fiscal Responsibility Law.  The GOE ended 2004 
with a very respectable primary fiscal surplus of 5.3% of 
GDP. 
 
5.   The GOE's gamble on an FTA with the U.S. seemed to be 
building upside and losing downside throughout the year.  In 
Fall 2003 it looked like Ecuador would be hard pressed to 
enter the negotiations together with Peru and Colombia by 
mid-year 2004.  However, the GOE pulled out all the stops, 
managed to resolve several commercial disputes, and not only 
entered the negotiations together with the others, but 
acquitted itself reasonably well in the negotiations 
themselves. 
 
The Weak Underbelly 
------------------- 
 
6.   Unfortunately, short-term high quality economic 
management is not all Ecuador needs.  The GOE fell off its 
IMF program in February 2004, despite good fiscal policy, as 
its political weakness had allowed it to show almost no 
progress on structural reform during the previous year.  No 
real progress was made in 2004, either.  An attempt to turn 
over Petroecuador's "crown jewel" oil fields to private 
management early in the year failed when the Attorney 
General (reversing himself for the second time on the issue) 
determined that the bidding round was illegal under current 
Ecuadorian law.  The GOE submitted legislation to Congress 
twice to overcome this problem, and twice was forced to 
withdraw it in the face of almost certain defeat.  The GOE 
also submitted legislation to carry out modest reforms in 
the electric sector, but that legislation also went nowhere, 
as did proposals to turn over management of state-owned 
telecommunications companies to international management and 
to carry out an external audit of Petroecuador. 
 
7.   In the fall, Yepez took another stab at convincing the 
President to increase the price of (heavily subsidized) 
cooking gas. (Pozo had tried the same in 2003, with the same 
unsuccessful result.)  Although the early response was 
positive, the end of year political situation made this a 
non-starter, again. 
 
8.   Despite an oft-repeated message from the U.S. on the 
issue, Ecuador has made only limited progress on labor 
reforms.  The GOE did hire one child labor inspector for 
each province, as required under its own law.  It also 
issued a watered-down decree regulating subcontracting. 
However, real protection of the rights of workers in Ecuador 
remains to be implemented. 
 
2005: Another Year of Opportunity 
--------------------------------- 
 
9.   The good news for 2005 is that all or most of the 
opportunities Ecuador failed to take advantage of in 2004 
are still available.  There may even be a few new ones. 
 
10.  Two years of responsible fiscal policy, plus continued 
high oil prices, may pay off this year.  International 
analysts suggest that the GOE may be over financed in 2005, 
possibly by as much as $1 billion.  This is the result of 
expected increased disbursements by the international banks, 
oil revenues, and likely new placements of international 
debt.  This would take pressure off the local market for GOE 
debt, which was looking rather saturated in 2004.  Yepez is 
also planning $275 million in private debt placements, a 
swap of the Global 12 bonds and a $400 million bond issuance 
later in the year. 
 
11.  The IMF has grudgingly accepted the fact that GOE 
fiscal policy remains responsible and that the country, for 
the moment, has little need for the IMF's money.  It agreed 
in December to issue an assessment letter allowing funds 
from other international financial institutions to flow.  It 
also established an enhanced surveillance mechanism with the 
GOE, which amounts to quarterly reviews of GOE performance. 
The Fund, like us, remains very concerned about the long 
term given the lack of structural reform. 
 
12.  We expect the free trade agreement to be a major 
political and economic issue in 2005.  The conclusion of the 
negotiations will lead to an intensification of the national 
debate over the value of the agreement, and likely an 
increased effort in the drive to collect signatures and 
force a non-binding referendum on the agreement.  The 
general population seems uninspired by the FTA, but resigned 
to its inevitability given Colombia's and Peru's likely 
entry. 
 
13.  Yepez and his small band of reformers are making noise 
about resurrecting the hydrocarbon law and the electric 
sector reform, and have added to them a proposal for limited 
social security reform.  They suggest that the new 
congressional majority the government wields may allow 
passage.  We are not optimistic.  The new majority depends 
on support from the MPD and the Socialists, neither of which 
are likely to vote for any kind of economic reform, and the 
bitterness between the government and the Social Christians 
means that that party, which might be expected to support 
some economic reforms, is not likely to vote for any GOE 
proposal. 
 
Our Plan 
-------- 
 
14.  We are focusing our efforts on the short, middle, and 
long range as follows: 
 
15.  Short Range:  Crisis prevention and response.  This 
includes a focus on resolving the commercial disputes 
involving U.S. companies and combating the extremely bad 
policy initiatives which crop up on a regular basis (recent 
examples include regulations which would have destroyed the 
nascent credit bureau industry and legislation proposed by 
the powerful Social Christian Party to fix interest rates 
and otherwise hamstring the banking sector, which is still 
recovering from the 1999-2000 banking crisis).  We will also 
focus GOE attention on the need to comply with international 
labor standards to prevent Ecuador's exclusion from an 
Andean-U.S. FTA.  Our public affairs section, including its 
Information Resource Center, is also involved in 
congressional outreach, helping those interested in finding 
sensible alternatives to bad proposals. 
 
16.  We continue to support Ecuador's participation in FTA 
negotiations through key technical assistance, studies and 
training.  This assistance has been vital to the GOE's 
successful participation in the negotiations.  Moreover, we 
have engaged in a broad ranging public awareness campaign 
that seeks to inform the public about the benefits of the 
FTA.  The goal is not only to gather supporters, but also to 
make people aware of the opportunities the agreement will 
bring. 
 
17.  Medium Term:  We look for targets of opportunity, 
either institutions which can be reformed because committed 
reformers are in leadership positions or policy reforms 
which seem to have sponsors and support.  For several years 
now we have supported the Internal Revenue Service (SRI) to 
improve tax policy and tax administration. Our support has 
resulted in a dramatic increase in tax collection over the 
last five years and the establishment of the SRI as one of 
the few effective and well-respected institutions of the 
GOE.  We are currently focusing assistance on building SRI 
capacity to collect from the largest taxpayers.  USAID has 
designed and is supporting a major reform of the Ministry of 
Economy.  Over 2-3 years the program will restructure the 
day-to-day operations, personnel systems, accounting and the 
information management system.  A similar reform is underway 
at the Superintendency of Banks, with USAID's assistance. 
In addition we are supporting Yepez effort to develop and 
implement a broad reduction in unnecessary personnel across 
the public sector, which will help reduce salary 
obligations, a huge burden on the budget and streamline 
government services. We will do what we can to advise and 
support Yepez in the reform projects he is pushing, and have 
our own suggestions, as well.  Though we are encouraging the 
GOE to take steps immediately to better protect worker 
rights through administrative means, substantive labor 
reform is another goal more likely to be achieved over the 
medium term. 
 
18.  Our public diplomacy strategy targets Ecuadorian 
reformers, sending them on International Visitor programs to 
expose them to the benefits of responsible policies. 
Publications, CD-Roms and other material from our 
Information Research Center, as well as the Embassy web 
site, provide information opinion leaders need to bolster 
their arguments.  Speaker programs by US economic experts 
and Embassy staff also are spreading the word.  We will be 
fully engaged in a very public campaign to help Ecuadorians 
understand the benefits of the FTA for their country. We 
hope to continue the AID-funded FTA public awareness 
campaign that has already reached some 10,000 Ecuadorians. 
 
19.  Long Term:  Despite our efforts and those of our allies 
on economic reform in the medium term, we believe it likely 
that the FTA will be the only significant economic reform of 
the final two years of the Gutierrez administration.  Our 
long-term effort is centered on two key issues, making the 
most of the FTA as an opportunity for reform and building 
support among the youth for future reforms. 
 
20.  Ecuador will have to undertake a great deal of 
institution building to comply with the terms of the FTA. 
Our assistance will be critical to help the GOE adopt 
standards, train its people, approve legislation and create 
institutions.  We can use FTA-mandated reforms in Customs 
and intellectual property rights areas as a vehicle to clean 
up the former and improve enforcement efforts on the latter. 
In areas such as technical barriers to trade, competition 
policy, labor regulation and environment control the GOE 
will depend to a great extent on our assistance to implement 
the agreement.  Even where international financial 
institutions are present to provide resources to address 
some of these issues, USG assistance is essential to provide 
tailored support, and to help address specific USG 
interests. 
 
21.  Our public diplomacy efforts focus on increasing the 
public's understanding of the real benefits reforms will 
provide in accomplishing Ecuador's long term social and 
economic development goals, particularly among the young 
leaders of today who will shape Ecuador's future.  We are 
encouraging qualified candidates to apply for Fulbright 
scholarships to study in the United States and supporting 
the English teaching programs that give them the edge they 
need to compete internationally.  We are focusing our press 
and outreach programming on such issues as transparency in 
government, fighting corruption and the need for greater 
civic participation in order to encourage the successor 
generation to carry on fight for continued reforms. 
 
Resource Constraints 
-------------------- 
 
22.  We are concerned that reductions in Economic Support 
Funds for Ecuador, as well as Nethercutt amendment and other 
sanctions may significantly affect our ability to help our 
allies in the GOE move economic reforms forward.  It would 
be particularly unfortunate if we were unable to help them 
take advantage of the FTA to spur reforms along, and would 
directly damage both our commercial and our strategic 
interests in Ecuador. 
 
KENNEY 
 
_______________________________ 
1How much