Quito, Ecuador
August 10, 2000

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Köhler:

1. Attached is a supplement to the memorandum of economic policies of the Government of Ecuador for 2000, dated April 4, 2000. It describes recent developments under the economic program, including key policy adjustments to alleviate some of the social costs of the economic crisis, and to keep the program on track. Also attached is a supplement to the technical memorandum of understanding which lists the policy actions to be taken prior to consideration by the Executive Board of the Fund of the first review of the Stand-By Arrangement.

2. As described in the supplement, the review process has been delayed due to ministerial changes in the government. We therefore request that the schedule of purchases under the Stand-By Arrangement be rephased, and that the third purchase, initially scheduled for end-August, be eliminated together with its corresponding review, and that the amount of this purchase be divided equally into the three remaining purchases (which will all remain subject to the completion of a review).

3. The Government of Ecuador request waivers for the non-observance of the performance criteria for central government non-interest payments arrears for end-April, and for the increase in cooking gas prices in July. Furthermore, the Government of Ecuador requests that the end-August indicative target for the floor on the “excess” freely disposable international reserves of the central bank be converted to a performance criterion.

4. The Government of Ecuador reaffirms its commitment to maintain close relations with the Fund and consult on the adoption of policy measures that may be needed during the period of the program.

Attachments

Ecuador—Supplement to the
Memorandum of Economic Policies

I. Background

1. The economic program that the administration of President Noboa put in place in March this year, and which is supported by a Stand-By Arrangement from the Fund, has already made good progress in stabilizing financial conditions and laying the basis for economic recovery. This memorandum describes recent developments under the program, including key policy adjustments to alleviate some of the social costs of the economic crisis, adapt to recent developments and keep the program on track. Except as modified in this memorandum, the objectives, policies, targets, and commitments of the economic reform program remain as described in the original memorandum of economic policies dated April 4, 2000.

II. Recent Developments

2. Macroeconomic developments under the program generally were as expected or better.

• Economic activity in the first half of 2000 appears to have held up better than expected. Real GDP fell by about 1½ percent (year-on-year) in the first quarter; investment fell sharply, but the decline in consumption appears to have bottomed out. Manufacturing sales increased slightly in the first five months of the year; unemployment has declined marginally; and business confidence indicators have improved. However, inflation is running at a much higher rate than projected, as prices have adjusted more rapidly to the earlier depreciation of the sucre.

• The fiscal position is stronger than projected. The NFPS was broadly in balance in the first four months of the year, against an expected deficit of 2.4 percent of revised GDP in the program. Revenues exceeded program estimates by the equivalent of 1.2 percent of GDP, owing mainly to stronger oil prices (US$23 a barrel in the first half of the year compared to US$20 a barrel assumed in the program) and more buoyant tax revenues. Expenditures were below program by 1.1 of GDP, mainly reflecting shortfalls in investment spending that we expect to be reversed in the second half of the year.

• The banking system is more liquid than anticipated. The unfreezing of US$1.2 billion of time deposits in open banks, which began on March 13, proceeded faster than expected as many banks converted to cash the bank bonds that were issued in lieu of frozen deposits. About US$560 million of frozen deposits were paid out in cash in the period March–June, but the deposit base of the banking system increased by about the same amount, suggesting that most of the time deposits unfrozen have remained in the banking system. However, banks’ external credit lines fell by a further US$38 million in May (to US$774 million), bringing the cumulative decline this year to about US$200 million; credit to the private sector remains flat; and banks’ nonperforming loan ratio reached 47 percent in June.

• The dollarization of the economy is proceeding rapidly. Central bank sucre liabilities that are legally required to be fully backed by free disposable reserves (FDIR) have fallen sharply, reflecting maturing central bank sucre-denominated bonds and a decline in sucre currency in circulation. “Excess” FDIR (i.e., above the amount needed for the required backing of sucre liabilities and bankers’ deposits at the central bank) increased to US$256 million by end-April (adjusted for the accumulation of external arrears and shortfalls in program disbursements), US$90 million above the program target, and further to US$334 million by end-May.

• Program performance criteria. The quantitative performance criteria for April were met with the exception of that for domestic non-interest payments arrears. Data on the end-June quantitative performance criteria will be supplied to the Fund prior to consideration of the first review by the Executive Board.

3. Several policy measures have been implemented:

• A package of fiscal revenue and expenditure measures was introduced on May 25. This included: (i) increases in the prices of diesel and gasoline of 66–92 percent, and in other fuels of between 90–333 percent; (ii) elimination of the import tariff surcharge on electric appliances, parts and accessories, agricultural machinery, and second-hand engines (no reduction was assumed in the program); (iii) increases in public sector pay that averaged about 60 percent (in addition to a 10 percent public sector wage increase granted in April, the program had provided for further increases of 20 percent each in July and October); (iv) an increase in the monthly cash transfer to the poor (the bono solidario) of 75 percent (the program had provided for 50 percent); (v) increased spending on rural housing, pensions, child health and education programs, and infrastructure; and (vi) increases in electricity tariffs of up to 50 percent with monthly adjustments thereafter.

• Steps have been taken to keep the banking strategy on track. In June, the Junta Bancaria approved resolutions that: (i) establish a mainly voluntary scheme to restructure large viable debts to banks of households and corporations, with incentives for creditor and debtor participation; (ii) solve the main problems detected in the creation of the bank liquidity support fund; (iii) establish loan classification and provisioning rules according to international standards; and (iv) strengthen “fit and proper” requirements and internal control procedures of banks. In addition, the Junta Bancaria approved a strengthening plan for the superintendency of banks, and rules for access to the central bank’s liquidity recycling facility have been clarified to ensure the participation of banks whose capital adequacy ratio falls below the regulatory minimum provided they have an agreed capital strengthening program with the central bank.

• Discussions with external creditors also have moved forward, although more slowly than originally hoped. A meeting was held with private creditors on May 16 to discuss Ecuador’s adjustment program and medium-term economic prospects to lay the basis for a debt exchange offer in late July. Negotiations to normalize relations with Paris Club creditors were held on May 18–19, and it is the government’s intention to conclude the negotiations at a second meeting in early September.

III. The Government’s Macroeconomic Program for 2000

4. The key objectives of the program and broad strategy set out in the original memorandum of economic policies remain unchanged.

5. The macroeconomic framework of the program has been revised slightly, as indicated in Box 1 below. The revisions take into account indications that the economic activity appears to be holding up better than expected, inflation will be higher than programmed, and oil exports are likely to perform better than projected, increasing the external current account surplus.

IV. Fiscal Policy and Social Safety Net

6. The combined fiscal deficit target (in U.S. dollar terms) of the program remains unchanged. However, the composition between the targets for the nonfinancial public sector (NFPS) and the quasi-fiscal balance of the central bank have been revised slightly to take account of a negotiated reduction in the interest rate (from 12 percent to 6 percent) on most of the central bank’s portfolio of government bonds (resulting in lower interest payments and a smaller deficit of the NFPS, and a corresponding reduction in the quasi-fiscal surplus of the central bank). In relation to GDP, the targeted fiscal adjustment in 2000 is now larger because nominal GDP for 2000 has been revised upwards mainly to reflect the higher inflation and consequent different real exchange rate path. The combined fiscal deficit would decline from 7.2 percent of GDP in 1999 to 2.7 percent of (revised) GDP in 2000, consistent with a reduction in the NFPS deficit over the period from 6 percent of GDP to 2.8 percent (Box 2). In spite of the increases granted in May, public sector wages would still fall sharply in real terms this year, and by 0.9 percentage points of GDP (to 6.3 percent) from 1999.

7. In terms of expenditure priorities, the most important objective of the government is to ensure that the adverse impact of the adjustment program on the most vulnerable groups is minimized. Efforts are underway to improve the targeting and efficiency of existing social spending programs, as well as developing approaches to poverty alleviation in the context of a structural adjustment loan from the World Bank. The government intends to maintain spending on social programs this year broadly equal to the level of 1999 in real terms. Priority also is being given to making up the shortfall in the public investment program to provide support for economic activity and poverty alleviation (in particular where projects are labor-intensive and/or provide access to vital services), and ensuring that long-term development objectives are not compromised.

8. For the remainder of this year, fiscal revenues will be safeguarded through four measures: (i) there will be no further reductions in import tariffs, including the temporary import tariff surcharge in 2000 unless compensating revenue measures are introduced; (ii) certificates of frozen deposits will remain ineligible for the payment of taxes and import duties; they also will be ineligible for payment in any financial institution, public or private, other than the issuer of the certificate, except at market prices; (iii) electricity tariffs are being moved to levels that will permit the full clearance of arrears to the public sector by electricity distribution companies, and to allow them to remain current on payments to the state-owned generating companies; and (iv) the elimination of the financial transactions tax, which is envisaged in the Ley para la Promoción de la Inversión y la Participación Ciudadana (Ley Trole II) submitted to congress in mid-July, will be delayed until end-2000 when the associated loss of tax revenue will be compensated by measures to be included in the forthcoming tax reform (see below). The government has already sent a letter to congress proposing this revised timetable.

9. The government brought forward to May many of the increases in fuel prices planned for July and October, and in some cases increased prices of fuels to levels higher than had been envisaged to pay for needed social spending and increases in public sector wages. To alleviate the social impact of the fuel price increases, the government delayed raising the price of cooking gas, which is important in the household budget of the urban poor. The Government of Ecuador requests a waiver for the non-observance of the performance criteria on the increase in cooking gas prices July. The timetable for further increases in domestic fuel prices, and for the increase in cooking gas prices originally programmed for July, will be determined at the time of the second review under the Stand-By Arrangement.

10. The second review under the Stand-By Arrangement also will: (i) set the performance criteria for end-October 2000; and (ii) reconsider the fiscal program to determine how much of any higher than programmed fiscal revenues will go into additional spending on social programs, and how much into deficit and debt reduction, the balance depending in part on the financing assurances for the program. The government will continue to keep fiscal developments under constant surveillance, and will take any additional steps that may be needed, including further increases in domestic fuel prices, to meet the fiscal objectives of the program.

11. In September 2000, the government will submit to the congress a proposal for a comprehensive tax reform aimed at increasing revenues from the tax system to help achieve fiscal sustainability while reducing fiscal dependence on oil revenues and distortions from taxation. The main elements of the reform will be as described in the original memorandum of understanding.

V. Monetary Policy and Financial Sector Restructuring

12. The government believes that market imperfections in Ecuador’s financial system require the continuation of some form of usury ceiling on interest rates, although it recognizes that the ceiling needs to be implemented in a manner that does not interfere with financial intermediation (in particular, that higher risk customers do not lose access to the formal financial markets). To give greater transparency to the setting of the ceiling and to reflect the latest market developments, the government has included in the Ley Trole II an amendment to the calculation of the usury rate, setting it at 1.5 times the central bank’s active reference rate on new commercial bank loans. The central bank also will apply the usury ceiling in a flexible manner, when needed, to counter stresses in the banking system.

13. To further safeguard efficient financial intermediation, the Junta Bancaria will reduce the provisioning that commercial banks are required to make on corporate and consumer loans that carry interest rates above 18 percent and 23 percent, respectively.¹ In any event, the special provisioning requirements are set to expire in March 2001. A time table for removing the restrictions on the fees that can be charged by financial institutions in lieu of interest payments will be established at the time of the second review of the program.

14. The government has made substantial progress in implementing policies to support the strategy to restructure and strengthen the financial system. A particularly important measure is the scheme approved by the Junta Bancaria last June to restructure the large debts of households and corporations. The scheme aims at facilitating economic recovery by easing the liquidity positions of firms and households, while improving banks’ asset quality. Incentives to encourage creditor participation include: (i) a flexible classification system for restructured loans is to be applied to loans entering the scheme to encourage banks to recognize implicit losses; and (ii) the failure to restructure a nonperforming loan within the timeframe provided by the scheme will result in the loan being reclassified as a “loss” with a 100 percent provisioning requirement. To encourage debtor participation, debtors who continue in arrears for more than 90 days after the deadline for restructuring would be subject to special foreclosure procedures (the “coactiva”) To facilitate these procedures, the Executive Board of the Corporación Financiera Nacional (CFN) will approve a resolution establishing a system for applying the “coactiva” to the nonperforming credits of private banks. In conjunction with the multilateral institutions, the government is developing mechanisms to monitor closely the implementation of the household and corporate debt restructuring scheme to ensure that it meets its objectives.

15. To provide incentives for the recapitalization of banks from private sources, an amendment to the financial institutions law was included in the Ley Trole II that will allow shareholders to retain ownership and control of a bank if its capital adequacy ratio falls below the regulatory minimum of 9 percent, but remains above 1.8 percent, provided a capital strengthening program had been agreed with the superintendency of banks. The superintendent of banks also will grant access, when needed, to such banks to the central bank’s liquidity recycling facility.

VI. Financing of the Program

16. Reassessing the prospects for net external financing (including recent disbursements of program loans from the World Bank and the IDB), the external financing gap for 2000 is estimated at US$1.4 billion (9.8 percent of revised program GDP). The government intends to meet this gap by means of exceptional support from the official international community and an orderly resolution with private external creditors to achieve a more sustainable debt and debt-service position.

17. The authorities have requested a meeting with Paris Club creditors in early September with a view to reaching agreement on the rescheduling of arrears and debt service obligations. The basis for the discussions with creditors will be the assumed financing needs of the government’s fiscal program supported by the Stand-By Arrangement with the Fund. In addition, the government intends to go to the market with a debt exchange offer in late July 2000 aimed at normalizing relations with external private creditors. The government will consult with the Paris Club and the Fund in advance of making this offer, with a view to ensuring that the offer is consistent with program financing, and the goal of restoring medium-term fiscal and external sustainability.

18. In June the government entered into negotiations with a foreign bank with a view to normalizing arrears of about US$218 million on external credit lines of intervened banks. In addition, meetings have been arranged with foreign creditor banks in July to seek the maintenance of their exposure under interbank and trade-related credit lines.

VII. Other Structural Policies

19. In the Ley para la Promoción de la Inversión y la Participación Ciudadana the government intends to further advance the structural reform process begun in the Ley de Transformación Económica approved by the congress last March. The new law will expand the scope of private sector activity, permitting the privatization of public utilities, the state airline TAME, roads, seaports and airports, postal services, and the extraction of nonrenewable natural resources. The regulatory frameworks for the petroleum, mining, electricity, and telecommunications sectors also are to be reformed in order to facilitate privatization and/or joint ventures. Measures also are included to further increase labor market flexibility, including longer probation periods for workers, use of part-time labor, and greater functional mobility for workers within firms.