Ecuador: The Consequences of Default

Ecuador: The Consequences of Default  <>
     December 18, 2008 | 1744 GMT


Ecuadorian President Rafael Correa
Ecuador’s decision to default on its debt opens the question of how the country will manage the investor abandonment guaranteed to result. A likely outcome will be that Ecuador will be forced to drop the U.S. dollar as its national currency, which comes with its own host of problems. Analysis
With the recent decision to default on $3.9 billion worth of foreign debts, speculation has begun to circulate that Ecuador will drop the U.S. dollar as its national currency. If Ecuador decides to go this route, it will need to invent a new currency system, essentially out of whole cloth. Ecuador’s decision to default made it the first country to turn to default as a way of managing the challenges of the international financial crisis (aside from Iceland, which is a special case <> ). The effects of falling oil prices have hurt Ecuador greatly. Oil makes up more than a third of the country’s exports, and with prices down nearly 70 percent from highs in 2008, Ecuador will find itself struggling to prop up an already strained oil industry while maintaining the social spending that forms the basis of Ecuadorian President Rafael Correa’s policies. Debt default is not new to Ecuador. The last debt default occurred in 2000, in the wake of a banking sector collapse that was partially a result of an explosion of credit in Ecuador and throughout the region. In this case, Correa has long threatened to default on the debt, which the government has deemed “illegal” or “illegitimate.” The default will take the form of the forced renegotiation of the value of a series of bond issues that Ecuador has released over the past decade, prior to Correa’s rise to the presidency. The effect of the default will be — in addition to cutting Ecuador’s debt obligations by about 40 percent — to immediately restrict Ecuador’s access to international capital. There is not an investor on the planet who finds debt-defaulting countries attractive, and in the current climate of highly restricted credit <> , Ecuador’s access to credit will be severely hampered. Ecuador’s total outstanding external government debt now totals around $6.1 billion, approximately 42 percent of which is financed through bonds. The remaining portion of external debt is financed through loans from international organizations and investors, and the replenishing of this source of financing will be frozen as investors react to the default. Much like Argentina after its 2002 default <> , Ecuador will be confined to its domestic capital markets for loans. Luckily, Ecuador’s banking sector has strong state controls and a number of domestically-owned banks. Of the $18.8 billion public and private banking sector, just over 14 percent of the sector’s assets are controlled by foreign interests (and thus reliant on increasingly scarce foreign financing). The remainder of the sector is in national hands, which gives the country some leeway because it means Ecuador has sequestered reserves of dollar-denominated cash. Unfortunately, switching to complete reliance on a domestic credit system poses major challenges to any capital-poor developing country, and it creates a particularly difficult situation for Ecuador. Ecuador adopted the dollar as its national currency to control the currency crisis that resulted from the 2000 debt default. This means that Ecuador has no control over its own monetary policy. Essentially, Ecuador is about to find itself in a position where it will have to expand the credit available to its population without being able to revalue the currency or print additional units. Thus, there is a big chance that Ecuador will be forced to abandon the dollar as its only currency in order to generate credit. With no choice but to create its own currency, the country will be faced with an extremely tricky economic situation. There are innumerable — and for Ecuador, unknown — problems associated with introducing a new currency. In the first place, it is difficult to get anyone to accept and use the currency. Money only has value inasmuch as people believe it has value, and new currencies must struggle to gain a foothold when they seek to replace an established and respected alternative like the U.S. dollar. As a result of this dynamic, the natural uncertainty about new currencies creates a great deal of pressure to use dollars on the side, creating an instantaneous black market for the dollar, which would undermine the official currency. Furthermore, Ecuadorians are not in a particularly good position to manage their own currency. Just taking into account the inexperience of the Correa administration and Ecuador’s eight-year stint with the dollar, the country quite likely has lost the expertise necessary for molding a new currency system. The biggest risk in implementing a new currency system that requires the outright creation and printing of a new currency is inflation. If the government begins to crank out new bills, it must carefully regulate the value of the money supply in order to avoid creating an inflationary spiral resulting from rapid monetary expansion.
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