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Ecuador private-sector incentives

13 July 2018 Arthur Dhont

Government continues shift away from policies of proceeding administration to target greater private-sector investment.

  • Relations between Ecuador and the International Monetary Fund are normalizing, leading to adoption of policy recommendations to promote private-sector growth
  • Tax breaks in for investments in major cities and coastal areas are likely to benefit the retail, tourism, construction, and agriculture sectors.
  • The cost of profit repatriation is likely to fall over a five-year horizon.
  • Greater flexibility in issuing debt will reduce the risk of ad-hoc tax and

On 4 July, the International Monetary Fund (IMF) concluded its Article IV mission to Ecuador, praising the country for a series of measures aimed at encouraging private-sector growth. However, it also raised concerns over the country's high budget deficit and rising public debt. Relations between Ecuador and the International Monetary Fund (IMF) have been improving gradually since 2014, when the IMF was invited back to the country after having been expelled in 2007 by former president Rafael Correa. Several recommendations made by the IMF during its previous visit in November 2017 were adopted in an Economic Promotion Law (Ley de Fomento Economico) passed on 21 June 2018.

The Economic Promotion Law includes a series of tax and state finance measures to promote private-sector investment and improve liquidity in the dollarized economy. The legislation introduces corporate tax breaks of eight years for new investments in the cities of Guayaquil and Quito and 15 years for investments in the Esmeraldas and Manabí regions, areas that suffered significant damage in an earthquake in 2016. The legislation also modifies the currency export tax (Impuesto Salida de Devisas: ISD), allowing the Ministry of Finance to gradually eliminate the tax from 2019, from its current level of 5%. This will reduce the cost of repatriating profits. New foreign direct investment will no longer be subject to ISD if companies sign new investment guarantee contracts with the government. ISD tax breaks also will exist for imports of raw materials and capital goods. Value-added-tax is partially suspended for low-income housing and agriculture. The legislation also grants the Ministry of Finance the discretional right to issue debt to maintain liquidity in excess of the prior legal debt ceiling of 40% of GDP. By 31 May 2018, aggregate public debt was USD48.37 billion, or 46.5% of GDP. Foreign debt was USD34.38 billion at that date.

Opposition supports allowing policy implementation

President Lenín Moreno has lost his ruling majority following the defection of 28 of the ruling PAIS Alliance (Alianza PAIS: AP)'s 74 legislators to Citizens' Revolution, a political movement created by former president Rafael Correa. Although the defectors have voted with the government on several occasions, the government can no longer rely on their full support. However, Moreno has been able to rely on small left-wing parties as well as the conservative Social Christian Party (Partido Social Cristiano: PSC) and the centrist SUMA, which voted with the government. The largest opposition party, CREO, led by Moreno's presidential election rival Guillermo Lasso, has complained that the government economic reform package does not go far enough but has not obstructed the initiative, choosing to abstain during the vote on the legislation. For future legislative initiatives, the government will have to rely on ad-hoc coalitions to achieve a majority. With further support from or abstentions by center-right parties, the government is likely to have the scope to promote further initiatives to encourage foreign investment.

Outlook and implications

Under Moreno, Ecuador has adjusted its policy stance to favor encouraging foreign investment. The Economic Promotion Law is a clear indicator of progress already made, and shows that despite recent political instability, the incumbent government enjoys sufficient legislative support to implement business-friendly policies. The latest IMF consultation indicates that relations between Ecuador's government and the institution are normalizing, leading to greater acceptance of policy recommendations made by the IMF. In IHS Markit's view, Ecuador is unlikely to seek an assistance package from the IMF. Recent debt sustainability indicators appear positive. Earlier this year, Ecuador's debt was among the weakest performers within international emerging markets, and its EMBI+ index is still out by 42% within 2018, versus deterioration of 16.7% for the EMBI+ Emerging Markets index. However, it has outperformed recently, encouraged by the government's more business-friendly stance. During July, Ecuador's average debt spread over comparable US Treasury bonds has fallen 14.2%, versus a 5.9% improvement in the wider index, a clear indicator of improving market sentiment.

The introduction of tax breaks will benefit multiple sectors including tourism, retail, agriculture, and construction in the country's two main cities and along the Pacific coast. The elimination of currency export tax will reduce the cost of repatriating profits. Allowing the Ministry of Finance greater flexibility in issuing debt is likely to reduce the risk of ad-hoc tax and tariff introductions to reduce dollar flight at times of illiquidity. By increasing the availability to foreign currency without recourse to foreign reserves, it increases scope in the next year for imports. However, consistent growth in the debt to GDP ratio from its current level will be an adverse indicator of debt sustainability over the three-to-five-year outlook. Plans to re-introduce bilateral investment guarantee treaties scrapped by the previous Correa administration indicate the government is sensitive to investor concerns around contractual risks, given the hydrocarbon-sector nationalization under the previous administration. A ruling by the Constitutional Court on whether the treaties are compatible with Ecuadorian sovereignty will provide a strong indicator of the scope for them to be reintroduced. Although the government lacks a majority and must achieve policy compromise with the opposition, it is likely to find support for further measures to encourage private-sector growth, including labor market reform, another recommendation by the IMF. Given Ecuador's ongoing reliance on hydrocarbon revenues, a fall in the oil price would provide an early indicator of the risk of policy reversal or modification of initiatives that reduce state revenues. Conversely, oil price appreciation would represent a positive indicator, giving the administration greater budgetary leeway.

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