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Ecuador quake fractures a fragile economy

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Ecuador quake fractures a fragile economy

Ecuador'searthquake in April is likely to worsen the country's already weak economic situationcaused by falling oil prices, but measures to finance the reconstruction,including tax increases and loans from the World Bank and other institutions,should benefit the economy in the long term, Alberto Rodríguez, the 's countrydirector for Ecuador, Peru, Venezuela, Bolivia and Chile, told S&P GlobalMarket Intelligence.

"Theearthquake hit Ecuador at a very difficult time … it's facing a very difficultfiscal situation with the fall of oil prices, which has reduced its revenuessignificantly," he said.

Furthercomplicating the scenario, Ecuador has cut public spending in recent yearswhile investing heavily in new infrastructure, including energy projects, butbusiness confidence in the private sector has fallen, partly due to regulatorychanges, Rodríguez said.

"Thishas created a tense macroeconomic environment," he said, adding theearthquake has brought "additional hardship."

Daysafter the quake in April, the World Bank announced a $150 million loan for Ecuador to aid in thereconstruction effort, but Rodríguez admitted more is needed. "Given thetough economic situation the country has been facing, we're aware that theresources needed for reconstruction are much more significant," he said.

As aresult, the World Bank is currently looking at restructuring other loans in itsportfolio, including two loans tied to building schools and water treatmentplants in the country, which could yield an additional $250 million in funds,Rodríguez said.

"Thegovernment may choose to request this or not," he said, adding the WorldBank is prepared to reallocate resources to the affected areas.

Thegovernment of President Rafael Correa has estimated damages at $3 billion, orabout 3% of GDP, but Rodríguez said a post-disaster recovery plan beingdeveloped by various institutions, and led by the Planning Ministry, shouldprovide more detailed information by early June.

Interms of the damage, Ecuador's energy sector, including new hydro plants,escaped the quake largely unscathed, but basic infrastructure along thenorthern coast was badly damaged, including buildings, hospitals and roads.

TheWorld Bank's own preliminary estimates put infrastructure damages at $1.1billion, but this does not include other related economic costs, such as lostindustrial activity, which may explain the government's higher figure,Rodríguez said.

Insurancewill cover some this, with catastrophe modeling firm AIR Worldwide industry-insuredlosses at up to $850 million, but the public sector will have to pick up mostof the tab.

Tofinance the reconstruction, President Correa has announced plans to raisetaxes, including a two-percentage point increase in the sales tax, known as theVAT, to 14% from 12%, a one-time tax on millionaires, and a temporary corporateincome tax hike.

Thesemeasures should generate about $1 billion a year in revenues, Rodríguez said,adding the VAT increase alone should contribute an extra $700 million to statecoffers.

Ecuador'ssales tax, at 12%, is one of the lowest in Latin America and increasing it is"a step Ecuador was probably considering even without theearthquake," the World Bank's Rodríguez said, adding such a move"seems reasonable" at a time when the government needs to supplementfalling revenue from oil exports.

But,in a research note on April 28, Moody's analyst Renzo Merino expressed concernabout the tax hike."In the short-term these measures will likely dampen private consumptioneven more," he said, adding that Ecuador was already in a recession beforethe earthquake struck.

Evenbefore the quake, credit ratings agencies Fitch Ratings and Moody's projectedEcuador's GDP would contract slightly in 2016, but now Moody's estimates thiscontraction will likely be between 2% and 3%, while Fitch sees the economyshrinking by over 2%.

"Ourview is that Ecuador is undergoing a complicated macroeconomic situation thathas been triggered mostly by the drop in commodity prices," Merino said.

FitchRatings' lead analyst for Ecuador, Richard Francis, agrees. "Ecuador wasin a hole before the earthquake, and now they need to plug even biggerhole," he said.

Ecuadoris contracting more external debt, mainly from multilateral institutions likethe World Bank and the International Monetary Fund, but also through bilateralloans from countries such as China, which recently signed a $2.0 billion creditdeal.

 "This will help plug some of the financinggap that was already there," Francis said, adding the earthquake makes itmore likely Ecuador will accept a possible IMF bailout package in addition toemergency funds.

SinceEcuador has little external debt amortization before 2020, and its interest torevenue ratio remains at a relatively moderate level compared to peers inMoody's B sovereign rating category, it also has room to take on more debt tofinance reconstruction, Merino pointed out.

Spendingon reconstruction should also boost the economy beyond the initial blip causedby the earthquake, the World Bank's Rodríguez said. "There is an upsidebecause of the amount of construction and employment that will begenerated," he said, adding this "upside" should kick in duringthe coming months once rescue operations shift to reconstruction.

Merinoagrees that Ecuador should return to "slight growth" in 2017 withhigher growth forecast for 2018 and beyond. Higher oil pricesshould also help, with Fitch estimating that average oil prices will rise by$10 a barrel to around $45 a barrel in 2017, which should boost exports."This should help alleviate their financing issues," Francis said.

Ecuadorfaces a presidential election in February 2017, which could create someuncertainty in decisions surrounding reconstruction, Francis noted, butPresident Correa will not be running for reelection.

Ecuadoris rated B3 by Moody's, which is the same as Argentina's rating following thatcountry's recent upgrade, also with a stable outlook. Even considering thereconstruction costs, Merino does not see any change in the stable outlookgoing forward.

GivenEcuador's ongoing economic troubles, things will likely get worse before theyget better, but it could be worse. Higher taxes and greater debt may be painfulin the short term, but with more money coming in Ecuador may not only cover itsreconstruction costs, but also start to plug its fiscal gap.