Ecuador: Chronicles of a Default Foretold

It’s better than magical realism: sovereign debt default on the basis of illegitimate bond structuring. That’s what Ecuador’s President Rafael Correa claimed last December after an internal audit of the country’s debt renegotiations (by previous administrations) revealed serious irregularities including improper actions by Salomon Smith Barney and JPMorgan (JPM), who are accused of negotiating bond deals without Ecuador’s authorization. It was a bold political decision loaded with the usual populist rhetoric (Correa called the bonds “a real robbery of the country”) but Correa’s strategy is to use the default as leverage to renegotiate the debt with foreign creditors.

At stake is Ecuador’s commercial debt (Global Bonds 2012, 2015 and 2030) because it involves $4 billion or 90% of Ecuador’s public debt. This year Ecuador was due to pay $30.6 million in May and in November in interest payments on $510 million in bonds due in 2012. Experts believe Correa is seeking a significant debt write-off but he is also pursuing other strategies to reduce Ecuador’s debt. According to Quito-based newspaper El Comercio, Correa’s government recently bought back $680 million in debt. Some believe Correa is trying to drive down the value of the bonds on international markets, allowing Ecuador to buy back the bonds at a fraction of the cost (see Washington Post story for more).

Neighborly Disputes

The default announcement was the first by a Latin American country since the 2001 massive Argentinian debt default and the second by Ecuador in less than ten years. The sum is not particularly large (compared to Argentina’s 100 billion default) and Ecuador has the money to pay it, but the real fear among foreign creditors is the precedent Ecuador might be setting for other emerging economies. Among the foreign creditors accused of making illegal loans are Brazil, Italy, Spain, and Venezuela. This is a departure from previous debt defaults which usually involved American and European banks.

Today, the government of Ecuador finds itself at odds with its neighbors. For example, Brazil and Ecuador found themselves in a heated lawsuit in Paris, France after Ecuador refused to pay a $243 millon dollar loan from Banco de Fomento de Brasi (BNDES). Brazil recalled its ambassador to Ecuador as a response and a war of words ensued between the two nations. The dispute was eventually settled and Ecuador paid Brazil back payments on the loan. But the damage was done and the fear now is that Correa’s regime cannot be trusted. That goes for friendly nations too. El Universal reported that the Venezuelan Ministry of Finance owns some $300 million dollars in structured notes (issued by foreign banks) through which the government invests in the yield of Ecuadorian bonds. So even Hugo Chavez would be hit by Correa’s actions.

The consequences can be severe for Ecuador given the current state of the global economy. The credit crunch and the recent drop in oil prices will certainly have a negative impact on Ecuador’s fiscal policies (Ecuador is projecting a $1.5 billion deficit in 2009). However, the long term effects are obvious—investors will shy away from places run by leaders like Correa.

“Ecuador is a serial defaulter,” said Arturo Porzecanski, an expert in international finance, emerging markets and Latin America economics at American University in Washington, D.C. “They defaulted in the 1980s, 1990s and this decade. A lot of other countries have had one or two defaults, but Ecuador tops them all.” Indeed, Ecuador has defaulted six times in its history (see Debt Defaults and Lessons from a Decade of Crises by Federico Sturzenegger and Jeromin Zettelmeyer).

Correa is a popular leader in Ecuador and throughout Latin America (according to Mexican polling firm, Mitofski he enjoys a 70% approval rating) but his popularity won’t last forever—particularly now that he will be forced to cut social programs as a direct consequence of plunging oil prices. This leaves Ecuador as the typical Latin American cliche—and cliches are known to express some truths. Yes, Latin America has improved its position in international capital markets, but the region has a long way to go still. Shoring up market confidence is the key to success in my view because investors see the region as one and the financial ailments of one country affects the entire region.

That’s why Ecuador’s case is a real tragedy for the region—it has done nothing to reduce investor suspicions and at the end of the day it’s Latin Americans who lose from actions such as Correa’s. This is like rounding up the usual suspects in a bad neighborhood. Credibility is everything when trying to build a strong and stable presence in financial markets. Sovereign debt defaults play a huge role in determining capital flows—who gets what and for how much? Right now Latin America has taken a step in the wrong direction.

Sources:

• Ecuador’s Audit Commission Finds `Illegality’ in Debt
  
• Ecuador defaults on foreign debt
  
• Calling Foreign Debt ‘Immoral,’ Leader Allows Ecuador to Default
  
• Ecuador in the spotlight as government seeks to renegotiate debt on its terms
  
• Correa: Se tratará de no pagar deuda ilegal
  
• Ecuador pays Brazil to resolve diplomatic spat
  
• To dowload the internal audit report (in Spanish) click here!

Comments

[Nick Gogerty:]

nice article. thanks for the contribution. it is sad that long term damage in terms of higher borrowing costs will impact the people of Ecuador long after Correa is gone.

Jan 23 09:49 AM

[notsosmart:]

its tough enough investing(if you can still call it that) here in the usa so why go offshore where the goal posts can be moved anytime by the gov?

Jan 23 11:35 AM

[PROXIMO:]

Informative post. Thanks Max.

Jan 23 03:42 PM

[kito:]

boy oh boy, you really should check your facts before throwing out bold statements like, "the damage is done" when referring to the ecuador/brazil dispute. did you overlook the recent meeting between ecuadorian foreign minister falconi and brazilian ambassador marques, where they agreed to "strenghten" their bilateral ties? the dispute between the countries was resolved and has done no harm to the latin american relations.

such an impossible scenario, that the banks, those beacons of stability, fiscal responsibility and fairness, coerced a small desperate nation into unfavorable terms during their restructuring. the only magical realism is the idea that our banks have any credibility whatsoever.

the "investors" that will shy away from ecuador will be the ones who can no longer unfairly manipulate the country and its policital/judicial system to their advantage.

Jan 23 09:10 PM

[Socialism c...:]

This is just a taste of the political strife yet to come from this global economic crisis. Mark my words: global war.

Jan 27 01:45 AM