Ecuador Binding Constraints to

GrowthIDB LAC Competitiveness & Growth

Seminar

Simon CuevaVicente AlbornozLeopoldo Avellán

September 2007

Applying GDM methodology to Ecuador

•Assessing underlying constraints to growth

•Examining diverse potential tree branches explaining low growth

•Judgment calls on the relative importance of the branches

•Use of factual & perception indicators with international comparisons, surveys, databases on enterprises and micro businesses

An intermediate growth performer in the region

•Above-average results in the 1970s (oil boom) and the early 2000s (oil + post crisis recovery)

•Below-average results in the other periods, particularly 1980s, 1990s (financial crisis) and currently

-2%

-1%

0%

1%

2%

3%

4%

Arg

entin

aB

oliv

iaB

razi

lC

hile

Col

ombi

aC

osta

Ric

aE

cuad

orE

lSal

vado

r

Gua

tem

ala

Hai

tiH

ondu

ras

Mex

ico

Nic

arag

uaPa

nam

aPa

ragu

ay

Peru

Dom

. Rep

.U

rugu

ayV

enez

uela

1951-59

Average

-4%

-2%

0%

2%

4%

6%

Arg

entin

aB

oliv

iaB

razi

l

Chi

leC

olom

bia

Cos

ta R

ica

Ecu

ador

ElS

alva

dor

Gua

tem

ala

Hai

tiH

ondu

ras

Mex

ico

Nic

arag

ua

Pana

ma

Para

guay

Peru

Dom

. Rep

.U

rugu

ayV

enez

uela

1960-69Average

-4%

-2%

0%

2%

4%

6%

8%

Arg

entin

aB

oliv

iaB

razi

l

Chi

leC

olom

bia

Cos

ta R

ica

Ecu

ador

ElS

alva

dor

Gua

tem

ala

Hai

tiH

ondu

ras

Mex

ico

Nic

arag

uaPa

nam

a

Para

guay

Peru

Dom

. Rep

.U

rugu

ayV

enez

uela

1970-79Average

-4%

-3%

-2%

-1%

0%

1%

2%

3%

Arg

entin

aB

oliv

ia

Bra

zil

Chi

leC

olom

bia

Cos

ta R

ica

Ecu

ador

ElS

alva

dor

Gua

tem

ala

Hai

tiH

ondu

ras

Mex

ico

Nic

arag

uaPa

nam

a

Para

guay

Peru

Dom

. Rep

.

Uru

guay

Ven

ezue

la

1980-89Average

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%A

rgen

tina

Bol

ivia

Bra

zil

Chi

le

Col

ombi

aC

osta

Ric

a

Ecu

ador

ElS

alva

dor

Gua

tem

ala

Hai

tiH

ondu

ras

Mex

ico

Nic

arag

ua

Pana

ma

Para

guay

Peru

Dom

. Rep

.

Uru

guay

Ven

ezue

la

1990-99Average

-3%

-2%

-1%

0%

1%

2%

3%

4%

Arg

entin

aB

oliv

ia

Bra

zil

Chi

le

Col

ombi

aC

osta

Ric

a

Ecu

ador

ElS

alva

dor

Gua

tem

ala

Hai

tiH

ondu

ras

Mex

ico

Nic

arag

ua

Pana

ma

Para

guay

Peru

Dom

. Rep

.

Uru

guay

Ven

ezue

la

2000-05Average

Source: ECLAC

A volatile and commodity-oriented economy

•2.4% average per capita growth over 1951-2005 •Growth accounting: TFP shortfalls for the income level; much more negative growth than other LAC countries•Economic booms led by a few export commodities despite some growth of industrial exports since the 1990s•Phases of growth with significant changes in average growth performance: high volatility, even for LAC standards•Relatively high investment levels and capital stock on a regional basis•Oil dependence: mixed evidence suggesting some Dutch disease; fiscal revenues and procyclical fiscal policies

0

50

100

150

200

250

300

350

400

450

1955

1958

1961

1964

1967

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

Chile Dominican Republic Ecuador Venezuela

Source: Center for International Comparisons of Production, Income and Prices, University of Pennsylvania

GDM decision tree

Low levels of private investment and entrepreneurship

Low return to economic activity High cost of finance

Low social returnsLow

appropriability

Costly international financing - High

country riskCostly domestic

financing

Geographical or natural resources

impedimentsBad

infrastructure

Low domestic savings: 1. Financial system

weaknesses 2. Inappropriate savings-

boosting framework

Poor intermediation: 1.Weak regulation

2. Weak enforcement of creditor rights

3. Asymmetric information 4. Thin domestic capital

markets

Low human capitalGovernment

failuresGovernment

failures Market failures

Macro risks: Financial,

monetary & fiscal stability

Micro risks: Property rights & Legal stability;

Corruption; Taxes; Inefficient public invt

decisions Information externalities Coordination externalities

Access to finance: a major business complaint

•Private sector surveys (World Bank Investment Climate 453 firms; Proyecto Salto for 17,626 micro businesses): access & cost of finance are major complaints, either for working capital or investment purposes •Statistical consistency: access to finance matters; firms highlighting financing constraints actual perceive them in their business decisions, use of bank loans and allocation of internal funds (not true for other mentioned constraints)•More sensitive for small & micro businesses:

•Credit seen by far as the most important requirement for success•Cumbersome procedures; collateral requirements; high interest rates

Source: Enterprise Surveys, the World Bank

0%

10%

20%

30%

40%

50%

60%

Eco

nom

ic a

ndR

egul

ator

yP

olic

y

Mac

roec

onom

icIn

stab

ility

Acc

ess

toF

inan

cing

Cor

rupt

ion

Cos

t of

Fin

anci

ng

Ant

i-co

mpe

titiv

e or

info

rmal

Tax

rat

es

Leg

alsy

stem

/con

flic

tre

solu

tion

Tax

adm

in.

Ele

ctri

city

48124

1,7185,621

2,492480

13063

1,65540

1,196176208

332

Technical asistance/ AdvisoryTraining

Credit for equipment, machinery, facilitiesCredit for inputs or merchandise

More product to sellBetter access to raw materials or productsImprove product presentation/ packaging

Improve processing technologyMore space

More or better workforceMore or better equipment

Pay off debtPromotions, sellers

Transport

0 1000 2000 3000 4000 5000 6000

Most important requirement for success

Source: Proyecto Salto survey

Access to finance and underlying reasons

•Weak credit history, macro instability: high costs of international finance, highest EMBI+ country risk (more than 500bp above LAC average)•Actual impact on domestic creditors limited for now: growing private foreign debt, (incl. back-to-back); limited banks’ foreign financial liabilities (6% of total) •Significant credit growth in recent years, in line with a recovery of depositor confidence after the 1999 financial crisis and the benign international environment•Ecuador macro crisis have traditionally included problems of access to intl finance•Low real lending rates by LAC standards but significant hidden costs: 22.5% implicit rate•Market segmentation, with widely variable real cost of credit; more acute transparency and competition problems for micro businesses / informal sector•Despite dollarization, lack of modern and comprehensive legal & regulatory environment on financial resolution & depositor’s protection => excessive precautionary liquid assets affecting financing costs?•Low levels of financial intermediation: creditor rights, weak judicial system, appropriability issues

Natural resources & human capital

•Diverse and abundant natural resources: oil, mining, productive land, forests, water, biodiversity, geographical position•Some geographical constraints arising from physical fragmentation: transportation and infrastructure costs; cultural and regional antagonism; decentralization trends and related risks•Human capital: mixed indicators and regional rankings:

•Favorable for primary education coverage, alphabetization, training for firms’ employees•Less favorable for secondary & tertiary education, standardized quality tests•Poorly for R&D spending, publications, patents•Large returns to schooling in the country but poor comparisons with other migrants in the US human capital in short supply, poor education quality •Waves of recent migration, particularly for segments with higher primary and secondary education coverage •Business surveys do not place workers skills as a critical issue

Infrastructure: some critical areas

•Mixed rankings with some relative strengths (water coverage, fixed and mobile phone lines) and weaknesses (paved roads, airport usage)•Progress on transportation and telecommunications (road concessions, large port & airport projects), not perceived as critical obstacles by businesses•Weakest links: oil and electricity

0

100

200

300

400

500

600

Ene

-00

May

-00

Sep

-00

Ene

-01

May

-01

Sep

-01

Ene

-02

May

-02

Sep

-02

Ene

-03

May

-03

Sep

-03

Ene

-04

May

-04

Sep

-04

Ene

-05

May

-05

Sep

-05

Ene

-06

May

-06

Sep

-06

Ene

-07

Petroecuador Private companies Total

* Excluding the impact of the decision to rescind Occidental contract in April Source: World Bank’s WDI, average includes Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Panama, Peru and Uruguay.

0

5

10

15

20

25

30

35

40

45

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

Ecuador Argentina Brazil Chile

Colombia Peru Average

Oil Production Energy Transmission and Distribution Losses

Oil: weak institutions, low investment

•Oil sector critical for export proceeds, GDP, fiscal revenues + subsidies•Steady decline in state-controlled oil production since 1994 (except Oxy, 4.5% average annual decline) vs. moderate growth in private production•Constraints not related to oil reserves (covering 23 years of current production); transportation capacity (since 2004, capacity usage of existing pipelines close to 59%) or world demand or prices•Institutional limitations:

•Limited attractiveness to foreign investors, legal limitations for public-private partnerships, shared-management contracts and risk-sharing•Petroecuador: under investment and technological obsolescence in the context of weak governance, transparency or institutional stability•Political interference: Petroecuador decisions and leadership, heavy and regressive oil subsidies (fiscal costs close to 6% of GDP + lack of competition)•Need for investments and transparent markets (exploration, refineries, commercialization) •Vested interests related to unions’ role and to beneficiaries of existing subsidies and related businesses (derivative imports, unloading and domestic transportation, smuggling)

Electricity: weak institutions, low investment

•High final electricity prices by LAC standards: constant threat of power outages; severe obstacle for businesses, recurrent issue•Highest energy losses in the region (more than 40% of transmitted and distributed energy) reflecting technical issues but also smuggling, obsolescence & management •Expensive and growing thermal generation; postponement of several large hydro projects despite natural generating potential: growing imports •State dominated sector (lowest private investment in LAC); clear segmentation by efficiency of distribution utilities; tariff subsidy magnifies the problem•Very low investment levels (0.16% of GDP over 1996-2000)•Vested interests play a role: weak management & collection help large debtors with some influence over managers’ nomination; legal calls for open nomination procedures nor implemented; political interference and governance issues•Regulatory framework on energy pricing + instability exacerbate existing problems and incentives for thermal vs. hydro projects•Hippos and camels - overall impact on growth: sectors where electricity is at least 2% of intermediate production add up to 47% of GDP; most (79% v.a.) grew below the national average since 2000

Macro vulnerability is still alive

•History of macroeconomic crisis episodes related to fiscal, external accounts & financial weaknesses – role of low oil prices & limited access to external financing•Recent macroeconomic performance largely reflects benign external environment•Dollarization cushions the economic impact of political uncertainty but reduces policy room of maneuver•Fiscal policy is largely procyclical: more than 80% of inflows to oil-related funds have been used since 2000 ; fiscal dependence on oil has grown•Elusive political consensus on sustainable fiscal management: significant budget rigidities arising from large eamarking of fiscal revenues: is this a second best alternative to limit fiscal procyclicality?

•Earmarking has constrained investment in key energy sectors, affecting long term growth•Budget implementation is highly discretionary, enhancing strong political actors and sidelining long-term poverty reducing projects•Procyclical fiscal policies are one of the reasons behind the pressures for earmarking protection•Chilean-style structural fiscal budget scheme could potentially help

Micro risks & appropriability: the weakest link

Political Stability

-1,50

-1,00

-0,50

0,00

0,50

1996

1998

2000

2002

2003

2004

2005

Latin America Average Ecuador

Government Effectiveness

-1,50

-1,00

-0,50

0,00

0,50

1996

1998

2000

2002

2003

2004

2005

Latin America Average Ecuador

Regulatory Quality

-1,50

-1,00

-0,50

0,00

0,50

1996

1998

2000

2002

2003

2004

2005

Latin America Average Ecuador

Rule of Law

-1,50

-1,00

-0,50

0,00

0,50

1996

1998

2000

2002

2003

2004

2005

Latin America Average Ecuador

Control of Corruption

-1,50

-1,00

-0,50

0,00

0,50

1996

1998

2000

2002

2003

2004

2005

Latin America Average Ecuador

Micro risks & appropriability: the weakest link

•Every survey or competitiveness assessment point to Ecuador’s weak institutions and governance problems; Ecuador performs poorly, even within LAC, on political stability, government effectiveness, regulatory quality, rule of law, corruption

•Exception: rather developed individual liberties– potential threats?

•Recurrent problems, widely perceived as a weakness for business environment; close to last in Transparency International corruption perception index; corruption in the top 3 reasons inhibiting private investment

•Growing lags with LAC on property rights & enforcement; after Argentina, Ecuador faces the largest number of FDI international arbitration procedures•Appropriability issues are clearly a binding constraint for Ecuador•Answers are uneasy; no quick fixes•Addressing social inequality and transparency may be the first steps•Fixing some specific areas to foster business environment may help

Business environment weaknesses

•Market concentration:•In the context of weak institutions, concentration could reflect overdue protection of inefficient sectors but is not necessarily hampering growth•Firm-level date show significant market concentration, particularly for state-controlled or heavily regulated sectors•Concentration correlated with more profitable sectors but not with high-investing ones (measured by net fixed assets growth)•No clear correlation with effective tariff protection; neither effective tariff protection is correlated with strategic value sectors

•Trade openness shrunk from 68.1% of GDP in 2000 to 55.4% of GDP in 2004, with limited new trade agreements signed compared to the region•Some taxation issues (red tape, tax rate structure, VAT drawback process) viewed as moderately problematic for doing business •Business costs: starting a business is relatively fast and inexpensive, hiring costs are among the lowest in LA while firing costs are particularly high

Industrial base and export diversification

•A weak industrial base for innovation and product sophistication:•One of the lowest indexes for manufacturing value added and exports in LAC despite recent growth•Limited technological complexity (medium and high-technology 15% of total v.a.; very low manufacturing v.a.; industrial competitiveness index weak)

• Limited export diversification:•Some recent diversification by product (5 non-oil exports share down from 79% in 1990 to 59% in 2006); number (exported items grew from 281 to 858); and destination (5 largest destinations fell from 78% to 62%)•Manufacturing exports remain largely concentrated by product (5 items - 51% exports) and geographically (East Asia – only 1,5%)

Product space and strategic value

Ecuador and other LAC countries: Open Forest

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1,600,000

1,800,000

2,000,000

1975 1980 1985 1990 1995 2000 2005

Ecuador Colombia Chile Brazil Argentina

46

81

01

21

41

61

82

02

2S

trate

gic

Va

lue

(00

0)

.5 1.5 2.5 3.5 4.5Density (inverse)

Petroleum Raw Materials

Forest Tropical Ag

Animal Prods Cereals

L Intensive K IntensiveMachinery Chemicals

ECU

•Hausmann and Klinger/UTEPI strategic value approach:• Ecuador’s productive capabilities in sparse parts of the product space; some movement in oil, forest and tropical agriculture but no high sophistication areas•Specialized in sectors wit limited global trade growth, value added & technological diffusion – not global star products•Open forest has increased since 1975, as for LAC average, and remains low by regional standards: moving toward high strategic value goods—far from existing products—would require effort and adaptation•Ecuador appears to have products with higher strategic value but farther away: high growth potential but harder to reach

Industrial policy?

• Some successful cases of product development (bananas, shrimps, strawberries, palm heart, broccoli) but also poorly designed or failed industrial policy experiences•Main lessons: key role of well-educated entrepreneurs, key market information trade agreements, combined public-private initiatives in some cases•Supporting policies: well-targeted and controlled credit access for small producers, public leadership to overcome perceived low appropriability of private returns, human capital policies, FDI attractiveness, some real exchange rate depreciation•Potential usefulness of public policies to address some coordination failures and technical expertise needs•However, bad experiences with strong state presence in some areas must always be reminded for caution

Policy recommendations

•Access to finance:•Access to international financing may become important beyond the current favorable situation, as highlighted by Ecuador’s experience and crises – contingent credit lines•Underlying factors are critical: legal stability, creditor rights, informality. Some role for public-private partnerships to foster well-designed access to small producers•Buttress efficient mechanisms for banking regulation, early prevention and resolution procedures, depositor protection•Enhanced attractiveness to foreign banks & banking transparency

•Macro stability:•Foster consensus over sustainable fiscal policies•Politically difficult but potential areas: budget transparency, prioritization of public investment and integrating planning and budget, protecting fiscal revenues to some sectors in bad times (structural fiscal balance?)

Policy recommendations

•Infrastructure:•Prioritize in oil and energy without hampering fiscal stability – role of oil-related funds, reducing oil subsidies•Increased transparency and governance for public controlled companies; business-oriented and professional management

•Appropriability:•The hardest to address – long term and comprehensive efforts•Institutional reforms for the Judiciary, Customs•Transparency and accountability (understandable budget objectives in terms of the coverage of social needs, financial management system, rules for public market attribution)