US embassy cable - 05QUITO1181

C O N F I D E N T I A L SECTION 01 OF 07 QUITO 001181 
 
SIPDIS 
 
DEPT FOR WHA/AND 
TREASURY FOR GIANLUCA SIGNORELLI 
 
E.O. 12958: DECL: 05/20/2010 
TAGS: EFIN, ECON, EC 
SUBJECT: ECUADORIAN FISCAL POLICY: LIVING ON THE EDGE 
 
REF: A. QUITO 900 
 
     B. QUITO 1054 
     C. QUITO 1159 
 
Classified By: AMBASSADOR KRISTIE KENNEY, REASONS 1.5 (B,D) 
 
1. (C) Summary:  Minister of Economy and Finance Rafael 
Correa inherited a relatively responsibly-managed fiscal 
situation from his predecessors.  If he continues their 
policies, he should be able to meet his budget without great 
difficulty.  However, his early statements to the press have 
damaged Ecuador's financing prospects while increasingly the 
likelihood of resource demands from powerful sectors of the 
economy.  Most significantly, Correa is asking Congress to 
reform the fiscal transparency law, placing the funds 
accumulated in the FEIREP (petroleum stabilization fund) into 
the budget.  Our best guess is that, after raiding the 
FEIREP, he faces a financing gap of some $230 million for 
this year, if the International Financial Institutions (IFIs) 
disburse, a sum which could be dealt with as budgetary 
arrears.  However, the gap could approach $1 billion if 
Correa fulfills some of his more rash promises.  If the 
situation heads in that direction, the probability of 
default, a solution Correa has an ideological preference for, 
will certainly increase. 
 
2. (C) We continue to believe that IFIs (World Bank, 
Inter-American Development Bank, Andean Development 
Corporation) should strike a firm stance with the Palacio 
government, demanding responsible policies if they are to 
disburse.  We also believe that Palacio needs to hear, as 
often as possible and from as many sources as possible, what 
the likely consequences of default would be.  The only two 
Latin American governments to default over the last ten years 
lost power shortly afterward.  End Summary. 
 
3. (U) We have met with numerous informed parties over the 
past two weeks to discuss likely fiscal prospects for the 
GOE.  In meetings with the IMF resrep, IBRD, IDB and CAF 
representatives, the staff of the Fiscal Policy Observatory 
(a UNDP project), former Ministers and Deputy Ministers of 
Finance, some 15 visiting Wall Street analysts, and 
Ecuadorian bankers and businesspeople we found widely varying 
prognostications, but some common themes.  From these 
contacts we have compiled several scenarios for the GOE 
budget for the remainder of 2005 (see below).  Although a 
variety of differences of opinion and assumptions about the 
situation and GOE policy mean that projections of the 
financing gap vary widely, it is clear that the situation has 
gone from substantial over financing under the former 
government to a real risk of default.  While we believe 
default is not the most likely scenario, it cannot be ruled 
out.  Following is our analysis of the key points in the 
scenario. 
 
The Background 
 
4. (U) With record-high oil prices, Ecuador should be rolling 
in oil cash.  It is not.  There are several reasons for this, 
ranging from the profligacy of previous governments which 
left the GOE with high debts and exorbitant salary bills, to 
structural problems including the huge subsidies the GOE pays 
and heavy earmarking of revenues.  Perhaps the most important 
drain from Ecuador's oil windfall is its fixing of prices for 
petroleum derivatives, in effect a costly subsidy. 
 
5.  (U) Since the GOE, through Petroecuador, markets 
petroleum products at fixed prices well below market prices, 
when oil prices increase, Petroecuador's losses from these 
sales counterbalance a good part of its earnings from the 
sales of crude. In the above table, this is visible in the 
"sales of products" line under "petroleum," where we are 
projecting a loss of some $450 million from amounts projected 
in the budget.  These losses actually outweigh the gains from 
the increase in the oil price, for a net loss of close to 
$300 million dollars.  Of course, these figures ignore the 
FEIREP (petroleum stabilization fund), which we expect to 
collect some $670 million, an increase of $129 million. 
Thirty percent of the FEIREP was included in the budget, so 
new FEIREP revenues amount to almost $50 million. (See below 
for more on the FEIREP.) 
 
6. (U) Other important changes in actual revenues include an 
increase of more than $100 million in tax revenues.  This is 
the result of substantial increases in imports and the 
resultant customs duties in the first quarter, though the 
increase is expected to moderate as the year proceeds.  Under 
Yepez there was an expectation that he would under-execute 
outlays, which is traditional in Ecuador, which could have 
been expected to cover much, if not all, of the $114 million 
shortfall.  In any case, Yepez also had realistic hopes of 
accessing foreign markets in a significant way, which could 
have also been used to cover any shortfall. 
 
2005 Budget Scenarios - Gutierrez Government 
 
                             By Law     Yepez 
                                        Likely 
Total Income                 5432.6     5318.6 
  Taxes                      3186.7     3306.7 
  Petroleum                  1531.5     1249 
    Exports                   781.6      943 
    Sales of products         749.9      306 
"Stabilization" (20% FEIREP)   98.4      134 
"Health and Education" 
    (10% FEIREP)               54.1       67 
Autogestion                   561.9      561.9 
Total Outlays                5918.2     5918.2 
  Primary Outlays            5065.5     5065.5 
    Salaries                 2182.4     2182.4 
    Goods and Services        391.9      391.9 
    Transfers                 926.2      926.2 
    Other current outlays      36.7       36.7 
    Financial Investments      14.2       14.2 
    Capital                  1514.1     1514.1 
Primary Surplus               367.1      253.1 
Interest                      852.7      852.7 
Deficit                      -485.6     -599.6 
Financing                     485.6      485.6 
Net Credit                    504.3      504.3 
Disbursements                2248.4     2248.4 
Amortization                 1444.1     1444.1 
Adjustments                    18.7       18.7 
CETES (due)                   300        300 
Income and Disbursements     7681       7567 
Outlays and Amortization     7681       7681 
Financing Gap                   0        114 
 
The New Situation 
----------------- 
 
7. (SBU) The three scenarios detailed in the table below are 
based on Minister of Finance Correa's oft repeated statements 
regarding use of the FEIREP within the budget.  It is 
important to note that these three scenarios are unrealistic 
in several ways (which will be discussed below).  First, all 
three assume substantial disbursements by the IFIs, whereas 
those disbursements are only likely if the first (and least 
likely, we judge) of the three scenarios is implemented. 
Second, they do not take into account substantial rollover 
risk.  Third, none of these scenarios take into account any 
significant response to the fiscal pressures which have been 
unleashed by the Minister's statements.  Finally, the third, 
and even the second, scenario may assume more management 
capability than is present in the GOE.  In fact, the GOE may 
not be able to expend resources as quickly as Correa would 
like. 
 
Raiding the FEIREP 
------------------ 
 
8. (SBU) A raid on FEIREP resources is the basis for much of 
the new minister's plan.  The FEIREP, a petroleum 
stabilization fund, was established in 2002.  By law, GOE 
earnings from heavy oil production are to go into the FEIREP. 
 The FEIREP is then to be used 70% for debt buyback, 10% for 
education and health spending, and 20% for "stabilization." 
From his early statements as Minister, it is clear that 
Correa believed that moving these funds into the budget would 
allow him to substantially increase GOE spending in the 
current year.  Just as clearly, he has been sorely 
disappointed on this score. 
 
9. (SBU) In fact, while carefully adhering to the letter of 
the Fiscal Transparency Law which established the FEIREP, 
former Minister of Finance Mauricio Yepez had already done 
violence to the spirit of the fund.  The 10% of the fund 
intended for social spending (and, presumably, for increased 
social spending), had been used for current education and 
health spending, freeing up resources for other uses.  The 
20% for stabilization, presumably meant as savings in good 
years to balance against years when oil income was lower than 
average, had been dropped directly into the budget (to 
"stabilize" it).  However, the real centerpiece of Yepez' 
financing was "laundering" the remaining 70% through the 
Social Security fund (IESS) in order to use it to finance the 
deficit.  In 2004, all of the 70% was used to buy back debt 
from IESS, which then immediately bought new debt from the 
GOE, thus financing the budget.  Yepez planned the same 
destination for this year's 70%. 
 
10. (U) Estimates of the funds available in the FEIREP this 
year vary widely (from $600 million to $900 million, compared 
to $541 million used in budgeting).  We choose to use a $670 
million figure which comes from former Vice Minister of 
Finance Ramiro Galarza.  This is substantially higher than 
the number the Fiscal Observatory is using ($600 million), 
but less than some other estimates (including that used by 
Correa). 
 
11. (SBU) Correa's plan for changing the FEIREP, apparently 
announced before he knew that his predecessor already 
intended to use the fund for budget finance, may 
substantially impact the fiscal sustainability of the budget. 
 Correa announced that another 20% of the fund would go to 
social spending, for a total of 30%, 10% would go to science 
and technology, and 40% would go into "economic reactivation" 
or, if deemed useful, debt buyback. 
 
Continued RELATIVE Responsibility 
--------------------------------- 
 
12. (SBU) The three scenarios laid out in the above table 
illustrate three very different uses to which Correa could 
put the FEIREP.  In the "Conservative" option, all $670 
million from the FEIREP is used for budget financing 
(actually, 60% enters above the line, while 40% could be 
above the line or could be used for a "laundering" operation 
similar to that used by Yepez in 2004 - the net effect is 
probably the same, though it would be subject to the rollover 
risk issue identified below).  In this scenario, Correa 
continues the shell game his predecessor began, saying that 
30% of the FEIREP is being used for social spending, for 
example, but using the funds to cover spending which was 
already planned under Gutierrez, rather than making any 
spending increases. 
 
13. (C) We judge this scenario to be unlikely.  Correa and 
Palacio entered their current positions after years of 
criticism of the fiscal restraint of their predecessors.  It 
will be politically difficult for them to so obviously 
renounce their beliefs.  In the case of Correa, his whole 
academic career has been based on the idea that the state 
needs to serve as the engine of growth, and it may be 
intellectually impossible for him to implement the economic 
policies of the "crazy bird" or Woody Woodpecker Ministers of 
Economy who preceded him (to use his description).  That 
said, this policy does offer the opportunity to reduce the 
financing gap to a perfectly manageable $33 million. 
 
Splitting the Difference 
------------------------ 
 
14. (SBU) In the second scenario, Correa would increase 
spending by some $200 million, most likely targeting science 
and technology for some $67 million in new spending (ref c), 
and putting another $133 million into healthcare and 
education.  In this option, Correa would use 40% of the 
FEIREP funds ($268 million) for financing via the IESS debt 
buyback "laundry." 
 
15. (C) Although the resultant financing gap of some $234 
million is probably manageable via some combination of 
underexecution and arrears, we believe it is likely that IFIs 
would be unconvinced by this option, and would opt to cut 
their disbursements by some $200-$300 million.  At a level of 
$500 million, the financing gap is a serious problem, and 
could force a decision between paying salaries or paying 
debt.  Still, we judge this scenario most likely, as we 
believe it gives the Palacio government political (and, for 
Correa, intellectual) cover, which they perceive they need. 
 
Party Hearty, Rafael! 
--------------------- 
 
16. (C) This middle-of-the-road scenario is, however, clearly 
not the preferred option for Correa, because, as he sees it, 
government spending would not increase enough to stimulate 
economic growth.  Correa firmly believes that, "with one hand 
tied behind its back" as a result of dollarization (no 
monetary policy), Ecuador must use fiscal policy to spur on 
the economy.  He has argued at length in his academic 
writings that fiscal and monetary policies geared to keep 
inflation low are inappropriate to developing countries, and 
that inflation levels of 20-30% are optimal.  He will want to 
spend. 
 
17. (C) The third option has him adding the remaining 40% of 
the FEIREP to above-the-line revenues and spending those 
funds on schemes intended to stimulate production.  In 
particular, he has been talking about using state 
institutions (including Pacific Bank, owned by the Central 
Bank as part of the still-unresolved aftermath of the 1999 
banking crisis) to lend at subsidized interest rates, 
especially as micro-finance.  This policy would take the 
financing gap to an unsustainable $500 million, and since the 
IFIs are almost certain to withhold disbursements under this 
scenario, the financing gap would most likely approach $1 
billion. 
 
2005 Budget Scenarios - Palacio Government 
 
                               Most 
                Conservative  Likely    Preferred 
Total Revenue        5787.6   5787.6       5787.6 
  Taxes              3306.7   3306.7       3306.7 
  Petroleum          1249     1249         1249 
    Exports           943      943          943 
    Sales of 
      products        306      306          306 
  Total FEIREP        670 
    "Stabilization" 
      (20% FEIREP)    134      134          134 
    "Health and 
      Education" 
      (10% FEIREP)     67        67           67 
    Correa FEIREP     469       469          469 
  Autogestion         561.9    561.9        561.9 
Total Outlays        5918.2   6119.2       6387.2 
  Primary Outlays    5065.5   5065.5       5065.5 
    Salaries         2182.4   2182.4       2182.4 
    Goods and 
      Services        391.9    391.9        391.9 
    Transfers         926.2    926.2        926.2 
    Other current 
      outlays          36.7     36.7         36.7 
    Financial 
      Investments      14.2     14.2         14.2 
    Capital 
      Expenditures   1514.1   1514.1       1514.1 
  Correa FEIREP 
    ($670 mil.)         0      201          469 
    Economic 
      Reactivation (40%)0        0          268 
    Science and 
      Technology (10%)  0       67           67 
    Social 
      Investment (20%)  0      134          134 
Primary Surplus       722.1    722.1        722.1 
Interest              852.7    852.7        852.7 
Deficit              -130.6   -130.6       -130.6 
Financing              97.1     97.1         97.1 
Net Credit            115.8    115.8        115.8 
Disbursements        1859.9   1859.9       1859.9 
Amortization         1444.1   1444.1       1444.1 
Adjustments            18.7     18.7         18.7 
CETES (due)           300      300          300 
Income and 
  Disbursements      7647.5   7647.5       7647.5 
Outlays and 
  Amortization       7681     7882         8150 
Financing Gap          33.5    234.5        502.5 
 
Entering La La Land 
------------------- 
 
18. (U) Readers may be wondering whether the batteries in our 
calculators are running low to even consider the possibility 
that the GOE would intentionally implement such a blatantly 
irresponsible policy.  We assure you that our analytical 
abilities have not been affected by the altitude.  Rather, we 
are concerned that Correa, Palacio, and even Ecuadorian 
society at large, far from repelled, are attracted by the 
siren song of default. 
 
19. (C) Both Correa and Palacio suggested, in their first 
days in office, that a "political renegotiation" of Ecuador's 
foreign debt would be a benefit to the country.  One of 
Correa's first acts upon arriving at the Ministry was to 
request development of scenarios for default (ref a).  He has 
threatened IFI representatives that he would continue paying 
Ecuador's debts to their institutions "as long as you keep 
disbursing to Ecuador."  In conversation with EconCouns three 
months ago he lauded Argentina for its default and later 
suggested to an audience that this was an example Ecuador 
should follow. 
 
20. (U) Not that his audience would disagree.  For years now 
the drumbeat on the impossibility of Ecuador's meeting its 
debt burden has been constant, and we have hardly met an 
Ecuadorian who does not believe that paying the debt 
(understood by the man in the street to amount to 40% of the 
GOE budget) is an impossible task.  Nevermind that more than 
50% of the GOE's debt payments are domestic, mostly to the 
IESS.  As a concept, default is very popular in Ecuador, and 
very few Ecuadorians understand what its likely consequences 
would be.  If the default is blamed on the IFIs, and 
especially the IMF, which are refusing to finance the 
government because it is prioritizing social welfare above 
the profits of the evil debt holders (as we expect it would 
be), the populace would be ecstatic.  Although we continue to 
hope that Ecuador will step back from this brink, we do not 
rule out the possibility of default. 
 
Making Matters Worse 
-------------------- 
 
21. (U) Still, we have not concluded this gloomy picture. 
First, we need to consider new fiscal pressures.  Then, 
rollover risk and the prospect for new financing. 
 
Gimme, Gimme, Gimme 
------------------- 
 
22. (U) As the tables demonstrate, almost 45% of the GOE's 
primary outlays are salaries.  These are re-negotiated every 
year in painful processes, usually accompanied by strikes. 
In the last 18 months, teachers, state oil workers, state 
health workers, numerous ministries, and judicial employees 
have all gone on strike for higher wages.  Teachers were 
already demanding wage increases amounting to $120 million 
for 2006 before the change in government.  It is only 
reasonable to expect that teachers and health workers, at 
least, will demand that part or all of the new funds Correa 
is promising for their sectors for 2005 go to salary 
increases.  Petroecuador employees recently received an 8% 
wage increase, retroactive to January 2003, which the Palacio 
government has announced it will not challenge.  Other 
government entities are sure to follow this lead.  This 
decreases still further the prospect for implementation of 
the "conservative" scenario. 
 
23. (U) More immediately, it is a sure thing that the wage 
bill in the tables understates the actual bill.  Public 
sector employees have been granted increases in wages for 
this year as part of a long-term effort to standardize wages 
across the various ministries and agencies.  Yepez intended 
to keep these increases from affecting the wage bill by 
laying off employees (and had an IFI loan in place to pay 
their severance pay).  Only Ministry of Finance workers had 
been laid off when the Gutierrez government fell.  Correa has 
announced that, in a country with 12% unemployment, it would 
be "insane" to lay off public sector workers.  We don't yet 
have an estimate for the fiscal impact of the failure to lay 
off unnecessary employees. 
 
Rollover Risk 
------------- 
 
24. (C) Another problem which may face the Correa team 
earlier, rather than later, is the likelihood that a 
significant number of the holders of Ecuador's domestic debt 
will try to get rid of it.  There is no secondary market in 
GOE domestic debt, so it is not possible to judge accurately 
market sentiment.  However, the analysts, and a few holders 
of domestic debt, we have talked to have suggested that a 
significant portion of the private holders of debt, maybe 
50%, will want to unload. (Proving that we weren't the only 
ones listening to Correa's morning TV show pronouncements.) 
Banco de Guayaquil President Guillermo Lasso said that "you 
would have to be mad to hold onto GOE bonds."  And he should 
know, since his bank has a few. 
 
25. (C) At $450 million, private holders make up about one 
third of the debt the GOE needs to roll over in 2005.  Former 
Deputy Minister of Finance Ramiro Galarza described his 
scenario to us.  The GOE announces that it intends to buy 
back bonds.  Rather than the dead silence which was the 
response of the market to similar offers under Yepez, 
allowing him to approach IESS and buy back, and then sell 
again, the bonds, Galarza believes all those wanting to sell 
will be clamoring to do so.  As Ecuadorian law makes any 
official who carries out a transaction which "damages state 
interests" personally liable for the resulting financial 
loss, and as tradition is that officials face these charges 
upon leaving office, neither the Ministry nor IESS will be 
able to ignore private sellers willing to offer them a "deal" 
on GOE paper.  Only by increasing interest rates on bonds, 
perhaps quite substantially, will the GOE be able to roll 
them over.  This in stark contrast to last year's rollovers, 
where terms on the new debt issuances were quite favorable to 
the GOE.  As some have noted, there is likely a price at 
which the GOE can succeed in rolling over the debt.  However, 
this Minister came in promising lower interest rates, more 
loans, productive reactivation.  If Galarza's scenario comes 
true, Correa's inability to deliver will be painfully 
obvious, and that could happen within the next few weeks. 
 
Time - Not On Their Side 
------------------------ 
 
26. (C) The GOE's amortizations do not come evenly over the 
year, of course.  They will rise slowly from under $150 
million in June to over $175 million in August, drop to less 
than $50 million in September, and then shoot up to about 
$200 million in each of the final three months of the year. 
Two weeks ago Mauricio Yepez told us that he was uncertain 
that the new minister, given his inexperience, would manage 
to finance the budget through August.  We, however, expect 
that the real crunch will come in the last quarter. 
 
Mitigating Factor 
----------------- 
 
27. (U) One factor which may mitigate concerns is the chronic 
inability of the GOE to expend resources efficiently.  Funds 
provided to the National Development Bank last year for loans 
intended to generate growth and employment still sit unused 
in accounts at the Central Bank.  The NDB could not get them 
out the door.  The fear of retribution for "bad deals" as 
described above, locks much of the GOE bureaucracy in 
paralysis.  It has been suggested by some analysts that the 
only way the GOE can get large sums out onto the street in an 
expeditious way is via salary increases.  If Correa really 
wants to implement new "programs" it is unlikely he will be 
able to do so within the timeframe of the Palacio government. 
 That said, he could make many people happy very fast by 
giving in to salary pressure. 
 
Correa's Convictions 
-------------------- 
 
28. (C) We have sketched Correa and his views in previous 
reporting (refs a and b), and fill in the picture somewhat 
above.  However, we have also had the opportunity to discuss 
Correa with a variety of people who know him, some well, 
others less well, or who have met with him since he assumed 
his new position.  These discussions tend to confirm the 
conclusions we have already drawn.  Correa is intelligent, 
but allows his ideology to override his intelligence, a 
tendency which is transparent even in his academic writing. 
He is also extremely inflexible and unwilling to modify his 
views, even in the face of evidence.  In his public discourse 
he openly insults his opponents and uses ad hominem attacks 
frequently.  We wonder whether he will take suggestions and 
allow for open consideration on his staff.  We have heard 
from various contacts a similar refrain:  Correa will not be 
taught, he will have to learn for himself, and at what cost 
to Ecuador? 
 
Palacio's Premises 
------------------ 
 
29. (C) Numerous contacts have suggested that Correa may be a 
"fast-burning minister," and may not last six months (many 
with hope in their voices).  Other contacts, however, suggest 
that Palacio may also have an ideological preference for the 
radical statist policies Correa is promoting. The fundamental 
question is, how will Palacio react when presented by Correa 
with options which could lead to default? 
 
30. (C) Banco de Guayaquil President Lasso, an acquaintance 
and former patient of cardiologist Palacio, noted that the 
doctor, though not a politician, had lifted his political 
philosophy from his communist father.  Lasso did not think 
Palacio had drifted far from his father's views.  He also 
said that Palacio was insufferably conceited and that he had 
changed cardiologists to avoid dealing with Palacio's ego. 
Together with Palacio's early statement about "political 
renegotiation," such comments are reason for concern. 
 
Off-Budget Shenanigans 
---------------------- 
 
31. (C) Of course, there are other things the GOE can do to 
damage the long-term prospects of the country.  The Finance 
and Energy Ministers have been gleefully announcing that they 
will raid the IESS for $600 million to invest in 
Petroecuador.  Several schemes have been floated, the most 
recent of which has IESS buying bonds from a trust fund 
backed by the company's future crude flows.  Some 
commentators have noted that investing in a company which 
still has not published a balance sheet for 2004 and which 
has artfully avoided recent calls for an audit, may not be 
wise.  Manuel Vivanco, one of the three board members of the 
IESS told us last week that the IESS board would never 
approve such a scheme, and that he believed pensioners would 
burn IESS to the ground if they did.  An interesting battle 
may be brewing on the issue. 
 
So, What to Do? 
--------------- 
 
32. (C) We continue to believe that it is important for the 
IFIs to maintain a hard line, disbursing only where 
conditionality is clearly met and responsible policies in 
place.  We also believe that Palacio, and the rest of 
Ecuadorian society, need an education on the likely results 
of default for Ecuador.  USG officials are not the best 
messengers to deliver this message, as we will be seen by 
Ecuadorians as interested parties, but we have many contacts 
and friends who can help to spread the alarm. 
Chacon