Fitch revises Ecuador's outlook to negative; affirms at 'B-'

Press release from Fitch Rating

10 January, 2019:

Fitch Ratings has revised Ecuador's Outlook to Negative from Stable and affirmed its Long-Term, Foreign- and Local-Currency Issuer Default Ratings (IDR) at 'B-'.

A full list of rating actions is at the end of this rating action commentary.

KEY RATING DRIVERS

The Negative Outlook on Ecuador's rating reflects Ecuador's relatively large fiscal financing needs for 2019-2020 and the sovereign's uncertain access to funding sources in the context of tighter global financing conditions. A faster fiscal consolidation to reduce the funding gap is difficult and uncertain, especially as it could bring additional challenges for Ecuador's economic and political outlook. Ecuador's low level of international reserves and resulting weak external liquidity are an additional consideration.

Fitch estimates Ecuador's 2019 financing needs at USD9 billion, which include an estimated USD3.7 billion fiscal deficit, USD3.9 billion in amortizations and USD1.4 billion in anticipated sale of oil and other obligations. The government has identified possible sources of financing that are heavily reliant on oil-related financing, China and international markets. There is limited visibility on the timing and magnitude of funding from China.

Current market access for Ecuador is uncertain (yields are currently above 9% in the secondary market). External

financing conditions have become tighter in the context of rising U.S. interest rates and diminished central bank liquidity globally. Although China granted a loan of USD900 million to Ecuador in December 2018 (with a disbursement of half in December), pledges for additional funding do not yet constitute firm commitments in Fitch's view. The volatility of oil prices also adds an additional risk to the government's financing plans. Fitch expects Ecuador's financing needs to remain at roughly USD9 billion in 2020, including a Eurobond maturity of USD2.2 billion in March 2020.

In addition to the fiscal financing difficulties, Ecuador faces external liquidity pressures. Historically, Ecuador's international reserve levels have been low and volatile, and heavily reliant on sovereign external borrowing. While Ecuador is a fully dollarized economy, and therefore technically international reserves do not serve a traditional balance of payments purpose, the Central Bank of Ecuador is the country's and the government's payment agent, and as such needs a certain threshold of operational reserves, which private sector analysts estimate at around USD2billion. International reserves ended 2018 at USD2.7 billion or just over one month of current account payments and up slightly from US2.4 billion from year-end 2017.

Large fiscal deficits and increased reliance on expensive market debt have led to rapidly rising debt and interest burdens, which are eroding Ecuador's fiscal flexibility, especially in the context of dollarization. Fitch projects Ecuador's debt/GDP ratio will rise to nearly 55% of GDP by yearend 2019, up from just 35% in 2015. Furthermore, the interest burden has risen sharply and the government's interest/revenues will approach 10% in 2020, nearly double the 2016 level. Although the government has reduced the fiscal deficit significantly over the last three years to a preliminary estimate of 3.1% of GDP in 2018, Fitch expects the fiscal adjustment to stall over the next two years due in part to increased spending pressures coming from court-mandated pension payments beginning in 2019. As a result the debt/GDP ratio will continue to rise.

Fitch also believes that there are significant implementation risks to fiscal adjustment plans, given the sharp fall in the popularity of President Lenin Moreno. A December 2018 poll conducted by Cedatos showed his popularity fell to 34%, down from over 68% in January 2018. For example, further fuel subsidy reductions could prove politically difficult to implement. On the revenue side, recent oil price volatility highlights risks to a fall in prices for the government's budget (oil revenues represent roughly 20% of the total for the non-financial public sector).

Ecuador's economic growth remains lackluster, and Fitch expects growth to fall to just 0.6% in 2019 from 1.0% in 2018 due in part to the fiscal retrenchment underway (especially on the public sector capital expenditure side). Average five-year growth (2015-2019) is expected at just 0.6%, underscoring the severe economic constraints for the country as it tries to move away from the public sector investment led growth model under the Correa administration.

SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns Ecuador a score equivalent to a rating of 'BB-' on the Long-Term,

Foreign-Currency (LT FC) IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:

- Macroeconomic: -1 notch, to reflect Ecuador's lower growth prospects than rating peers and

weaker macroeconomic policy credibility given the large fiscal imbalances in the context of

official dollarization.

- Fiscal: -2 notches, to reflect growing fiscal financing constraints given the sovereign's large

borrowing needs and limited domestic financing options due to the shallowness of the local market.

Continued expected increases in the debt burden undermine fiscal flexibility and debt sustainability

while materialization of contingent liabilities could also increase debt burden in the future.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables

based on three-year centered averages, including one year of forecasts, to produce a score

equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to

allow for adjustment to the SRM output to assign the final rating, reflecting factors within the

agency's criteria that are not fully quantifiable and/or not fully reflected in the SRM.

RATING SENSITIVITIES

The main factors that could lead to a downgrade include:

-Tighter financing constraints that undermine debt repayment capacity;

-Economic weakness or instability that heightens public debt sustainability concerns;

-Political instability that undermines the government's policymaking capacity and willingness to

service debt.

The Rating Outlook is Negative. Consequently, Fitch does not currently anticipate developments

with a high likelihood of leading to a positive rating change. However, the main factors that could

lead Fitch to stabilize the Outlook include:

-Sustained easing of financial constraints and a diversification of funding sources;

-Further fiscal policy adjustments that narrow the budget deficit, ease financial financing

constraints and improve the trajectory of government debt/GDP;

-Improvements in the country's external liquidity position that provide a more ample buffer to

external shocks.

KEY ASSUMPTIONS

The growth, fiscal and external forecasts assume that oil production remains at 530,000 barrels a day in 2019, similar to year-end 2018 production. Fitch's latest projections expect average Brent oil prices at USD65 per barrel in 2019 and USD62.5 per barrel in 2020.

The full list of rating actions is as follows:

Long-Term, Foreign-Currency IDR affirmed at 'B-'; Outlook to Negative from Stable;

Long-Term, Local-Currency IDR affirmed at 'B-'; Outlook to Negative from Stable;

Short-Term, Foreign-Currency IDR affirmed at 'B';

Short-Term, Local-Currency IDR affirmed at 'B';

Country Ceiling affirmed at 'B-';

Issue ratings on long-term senior unsecured foreign-currency bonds affirmed at 'B-'.