IMF Executive Board Concludes 2016 Article IV Consultation with Ecuador
March 21, 2019
On July 8, 2016, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation [1] with Ecuador.
Ecuador’s economy continued to suffer from the combined fallout from an important worsening in the terms of trade and the strengthening of the U.S. dollar. During 2015, the terms of trade fell by 25 percent and the real exchange rate appreciated by 14 percent. As a result, government spending contracted, economic growth decelerated to 0.3 percent (from 3.7 percent in 2014), and the current account deficit worsened to US$2.2 billion (from 0.6 billion in 2014). Recent indicators point to a continued decline in domestic demand. Inflation has been declining in recent months and was 1.6 percent in May (from 3.4 percent at end-2015).
Fiscal strains have become more evident. Net oil revenues fell about 5 percent of GDP in 2015. The authorities maintained the deficit to GDP ratio at the level budgeted (also the same as in 2014) by lowering public investment and raising tax revenues, while non-oil current spending rose with social security costs, the public wage bill, and interest payments.
Despite the government’s important adjustment efforts, limited fiscal buffers and a shortfall in financing caused an accumulation of spending arrears and a need to recourse to domestic financing sources (with a drawdown in public deposits and new borrowing from the central bank). As a consequence, the central bank’s net international reserves fell by about US$1.5 billion (to US$2.5 billion) in 2015. The non-financial public sector has continued to reduce its net deposits at the central bank in the first few months of 2016, and recent international financing allowed NIR to increase to about US$3½ billion in early-June.
The banking system has large buffers but vulnerabilities are growing. During 2015, deposits in private banks declined by 11½ percent and banks responded by rationing credit (which contracted by 4½ percent in 2015). However, in the first quarter of 2016, deposits have increased and credit has begun to slowly expand (albeit at short maturities). Reflecting the slowing economy, non-performing loans are rising but remain adequately provisioned on average, and profitability in the sector has been deteriorating.
On April 16, Ecuador was hit by a devastating 7.8-magnitude earthquake. The number of dead or missing has reached 675, while more than 4,600 people are injured. Further, more than 33,000 people are now in temporary shelters. The authorities estimate the reconstruction costs to amount to about US$3.3 billion. Regrettably, the earthquake added pressures to an already-difficult balance of payments and budget situation. Damage to agriculture, commerce, and tourism and the need to import some of the materials for rehabilitation and reconstruction are estimated to widen the current account deficit by about 1 percent of GDP.
The authorities responded with rapid revenue mobilization efforts and expect emergency assistance from international financial institutions. An emergency fiscal package was submitted to the Assembly after the earthquake and should yield 0.7 percent of GDP in new revenues in 2016. The package increases the VAT rate by two percentage points for up to one year and imposes a one-time solidarity surcharge tax on wages, corporate profits, and personal assets. International Financial Institutions and agencies offered emergency financial assistance for about US$630 million (of which about US$460 million is new lending, and the rest is reorientation of existing loans).
Notwithstanding such efforts, a fiscal financing gap remains. Staff estimates the remaining fiscal gap at about US$2¼ billion in 2016 which is likely to require a delay in the planned repayment of spending arrears, a reduction in capital spending on projects not related to the reconstruction, and recourse to additional net domestic financing. As a consequence, staff projects an economic contraction in both 2016 and 2017.
Despite the weak prospects there are still downside risks in the event that oil prices fall further, external financing becomes further constrained, and or confidence in the economy begins to falter. The financial sector is exposed to both liquidity risks in the short term and to credit risks in the medium term. A resumption of the U.S. dollar appreciation may put additional pressures on competitiveness and external accounts.
Executive Board Assessment [2]
Executive Directors welcomed the authorities’ progress in reducing poverty and fostering social inclusion. However, they noted the weak outlook owing to the decline in oil prices, the strength of the dollar, limited buffers, tighter external financing conditions, and financial stability risks. Against this backdrop, Directors recommended implementing a comprehensive set of policies to preserve macroeconomic and financial stability and restore competitiveness. In this regard, Directors welcomed the authorities’ commitment to reforms, and looked forward to continued engagement with the Fund through dialog and technical assistance.
Directors welcomed the significant fiscal adjustment prior to the April earthquake and the timely additional measures implemented following the disaster. They considered it prudent to continue to strengthen the fiscal position, although a few Directors noted the need to avoid a sharp output contraction. Directors broadly supported a strategy relying on a gradual elimination of untargeted fuel subsidies, a permanent increase in the VAT rate and elimination of exemptions, as well as expenditure prioritization in favor of productive spending. While noting that public wages have been frozen since 2015, Directors emphasized the importance of continued adjustment of the government wage bill. Directors also recommended complementary measures to improve public investment management and eliminate arrears, while protecting the most vulnerable.
Over the medium term, fiscal policy will need to rebuild adequate buffers to create space for countercyclical policy. Directors welcomed the authorities’ plans to sell public assets to the private sector. If implemented, this would help close the budget gap and can increase foreign direct investment. Greater transparency would help build credibility and support for fiscal reforms.
Directors noted that the financial system is sound and well capitalized. However, the recent build up of vulnerabilities calls for measures aimed at preserving liquidity, supporting confidence, and enhancing crisis preparedness. Directors urged the authorities to avoid central bank financing of the budget and issuance of central bank notes, ensure a swift functioning of emergency assistance mechanisms for financial institutions, and continue to enhance supervision and prudential regulation. Over time, it would be important to gradually phase out interest rate ceilings and capital controls, introduce risk management tools, and diversify the deposit insurance scheme away from public debt. Directors also encouraged the authorities to undertake an FSAP assessment.
Directors noted that Ecuador experienced a large terms of trade shock, combined with a significant real exchange rate appreciation. To regain competitiveness, they recommended containing labor costs, shifting from direct to indirect taxes, and further enhancing labor market flexibility. They also urged the authorities to devote efforts at increasing competition in the goods, labor, and financial markets, and strengthening institutions. Directors welcomed the authorities’ intention to finalize the Multipart Trade Agreement with the European Union and recommended removing the temporary import surcharges as soon as possible.
Directors stressed the need for continued improvements in the statistical framework.
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[1] Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.
[2] At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm
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