III. ECONOMIC TRENDS AND OUTLOOK - Major Trends and Outlook Introduction. Ecuador is a small Andean country of 11 million inhabitants. The economy generates a gross domestic product (GDP) of around USD 15 billion and provides formal sector jobs for a million people. With 271,000 square kilometers, Ecuador is about the size of the state of Colorado and enjoys dramatic geographical diversity. The country consists of three distinct regions: the tropical lowlands of the Pacific coast, the mountains and valleys of the Andean Sierra, and the Amazonian rain forest of the Oriente. Until oil was discovered in the late 1960's, Ecuador was a largely agrarian country dependent on exports of agricultural commodities. Boom periods were linked to high demand periods for coastal crops, first cacao from the late 1800's until the 1920's, then bananas in the 1950's, shrimp in the 1980's, and bananas again in the early 1990's. From 1972 onwards oil development in the Oriente and a large expansion in external debt fueled a decade of explosive growth in public services, state enterprises, and extensive infrastructure development. Ecuador enjoyed economic growth averaging 9 percent annually during the 1970's. However, as oil prices fell, the Ecuadorian government failed to adjust rapidly by cutting the bureaucracy and implementing other structural reforms. Consequently the economy stagnated during the 1980's under the impact of the debt crisis, inflation, incomplete adjustment measures, and a volatile international oil market. The principal challenge of the 1990's will be to restore growth on a more sustainable basis through the implementation of a comprehensive structural reform program. Today, petroleum production and agricultural exports continue to form the pillars of the Ecuadorian economy. The largely state- operated petroleum sector remains extremely important, exporting about two thirds of its crude oil production of nearly 370,000 barrels per day. Oil generates over 40 percent of export earnings and nearly half of central government revenue. Ecuador is the world's largest exporter of bananas and a major producer of shrimp, which together account for a third of the country's exports. Ecuador's farmers also produce a variety of domestic consumption crops. Industry is largely oriented to producing for the domestic market, but regional economic integration is creating more export opportunities for manufacturers. The services sector provides some of the infrastructure needed for a modern economy and a significant tourism industry. Since his election in 1992, President Sixto Duran Ballen has begun to implement macroeconomic and structural reforms to modernize the state and lay a basis for sustainable economic expansion. Although oil production increased in 1993, lower oil prices, problems with banana and shrimp exports, and anti-inflation austerity measures inhibited growth. Ecuador's trade surplus shrank in 1993, but an influx of private capital and the nonpayment of debt service generated a balance of payments surplus and increased foreign reserves. The economy should recover moderately in 1994. Sound fiscal and monetary policies brought the public budget into near balance and cut inflation in half, enabling the government in the spring of 1994 to reach an agreement with the International Monetary Fund (IMF), a preliminary debt restructuring agreement with commercial bank creditors, and a rescheduling of official bilateral debt through the Paris Club. Progress has been slower in implementing President Duran Ballen's modernization program during 1993, but there are signs of renewed enthusiasm for structural reform. A law unifying the state budget, major legal changes in the internal revenue and customs systems, and the introduction of market-related fuel prices should put the government's finances on a firmer foundation. Using the new hydrocarbons law, the government is increasing private participation in both oil exploration and downstream operations. Proposed legislation should allow for private concessions in the telecommunications and electricity sectors. A capital markets law has set the stage for expanding Ecuador's stock markets, while a new financial institutions law should lead to modernization of the banking industry. New investment regulations and intellectual property reforms have improved the climate for foreign investors. A new agrarian law strengthens land tenure. Meanwhile, the government has continued to liberalize its trade regime. Free trade exists with Colombia and Venezuela, while third country imports pay duties in the 5 to 20 percent range. The government is reforming the corrupt and inefficient customs administration and has applied for accession to the General Agreement on Tariffs and Trade (GATT) and its successor, the World Trade Organization (WTO). While these steps have been laudable, private sector confidence remains low, reflecting the slow implementation of privatization and other measures. The government also faces a difficult situation with Congress, where the government parties do not enjoy a working majority and must negotiate with opposition parties to enact legislation. The public sector remains extremely inefficient, and more privatization is needed in the telecommunications, electricity, and petroleum sectors. The IMF and bank agreements, recent government efforts to move its legislative agenda forward, and the appointment of a new team to lead the modernization/privatization effort have caused increasing optimism that the pace of change on structural reforms will accelerate in the remaining two years of the Duran Ballen administration. Economic Growth. In the early 1990's, the last phase of the banana export boom, increased oil production, and the outgoing Borja administration's expansionary fiscal policy helped fuel GDP growth of 5.0 percent in 1991 and 3.6 percent in 1992. As a result of the macroeconomic stabilization program introduced by the administration in September 1992 and weaker markets for Ecuadorian exports, real economic growth slowed to 2.0 percent in 1993. The petroleum sector was the contributor to GDP expansion for the third year with real growth of 11.5 percent in 1993. After registering average annual growth of more than 5 percent for the past 5 years, the agriculture and fishing sectors fell by 1.7 percent due to declines in banana and shrimp production. Manufacturing growth slowed to 2.5, while the construction industry fell by 4.3 percent. Utilities grew by 2.1 percent. The service sectors grew by 3.4 percent growth, primarily due to increases in financial services. On the demand side, preliminary 1993 data indicate that a 1.2 percent drop in government consumption was more than offset by private consumption growth of 2.5 percent, resulting in an increase in the overall consumption share of GDP to 78 percent from 75 the previous year. Private gross fixed capital formation grew by 4 percent, while public investment collapsed, dropping 11.3 percent. Overall, investment spending grew a modest 1.1 percent and continued to account for 20 percent of GDP. The government has set GDP growth targets of 3.2 percent growth in 1994 and 4.0 percent in 1995, again driven by expanded oil production. However, government efforts to increase tax collections and hold public investment to 1993 levels, suggest that the Development Council (CONADE) projection of 2.5 percent growth in 1994 may be more realistic. Over the longer term, economic revival will depend on the success of reforms designed to provide opportunities for market-based development and to integrate Ecuador into the regional and global economy. Inflation. Having inherited four years of inflation in the 50 percent range, the Duran Ballen administration set reducing inflation as one of its top economic objectives. After jumping 60 percent in 1992 as adjustment measures released repressed inflation, urban consumer prices only rose by 31 percent in 1993 on a year-on-year basis due to the slow nominal depreciation of Ecuador's currency against the dollar, tight fiscal policy, the freezing of nominal fuel prices, and a general economic slowdown. Monthly inflation peaked in May 1993 at 4.5 percent after a crisis in confidence over the government's commitment to economic reform, but moderated over the rest of the year. A second round of fuel price increases led to a 4.0 percent inflation surge in February 1994. Price behavior for the first five months of 1994 suggests that inflation will slow to around 25 percent by year-end, but may not meet the government's 20 percent target. Macroeconomic Stabilization and Fiscal Policy. While Ecuador's public sector budget deficit has not been as large as some other countries, the start-stop nature of spending, alternating periods of tight fiscal discipline with periods of loose spending, helped to stoke demand and keep inflation high during the 1986-1992 period. Moreover, the government had no control over revenues earmarked for specific programs or spending plans of independent agencies and state enterprises. The deficits were financed by the accumulation of arrears to foreign banks and suppliers, lending from official multilateral and bilateral institutions, and limited sales of securities to the private sector. Meanwhile, the Central Bank 's own "quasi-fiscal" deficits, caused by subsidized lending to both public and private sector enterprises, were for many years financed by inflationary monetary emission. By the time Sixto Duran Ballen took office as president in August 1992, the Ecuadorian economy was in urgent need of macroeconomic stabilization and meaningful structural reform. Inflation was accelerating, the public sector deficit was approaching 7 percent of GDP for the year, and international reserves had fallen sharply. An adjustment program introduced in September 1992 addressed these problems by increasing government revenues via substantial gasoline and electricity price hikes, devaluing the sucre by 35 percent and liberalizing the foreign exchange regime. The Public Sector Budget Law enacted in October 1992 brought state agencies and companies accounting for half of public sector spending into the budget process, curtailed revenue earmarking for unrelated expenditures, and empowered the Ministry of Finance to control costs. The stabilization program was successful in reducing the 1992 deficit to 2.5 percent of GDP, although short-term inflation went up. In 1993 the consolidated public sector deficit, including the state enterprises, amounted to 0.4 percent of GDP. Tight spending control made possible by the new budget law kept the non-financial public deficit to 0.5 percent of GDP, while the May 1992 monetary policy reform enabled the Central Bank to run a quasi-fiscal surplus of 0.1 percent of GDP. The public bureaucracy was reduced by 21,000 positions (although most of those laid-off appear to have been contract rather than permanent employees) and central government sucre deposits at the Central Bank increased by 53 percent during the year. The positive market response was reflected in the slow depreciation of the sucre and the fall in 90-day sucre CD interest rates from a high of 65 percent in September 1992 to 29 percent by the end of 1993. However, the stabilization process was far from smooth. Uncertainty over the direction of economic policy led to a spike in inflation and interest rates in April and May of 1993, the government failed to agree to an IMF program, the sucre price of fuels was frozen, and the structural reform program was stalled. Consolidated nonfinancial public sector expenditures during 1993 reached about 27 percent of GDP. According to Central Bank records of actual expenditures, the central government (including autonomous agencies, but excluding local government, military capital expenditures, social security, state enterprises, and public financial institutions) spent USD 1,962 million in 1993 or 13.5 percent of GDP, including USD 261 million on interest payments. Excluding debt service, the central government devoted 44 percent of its budget to social services, including 25 percent on education and 7 percent on health. Economic services accounted for 16 percent of the non-debt budget, with irrigation projects soaking up 11 percent, while infrastructure spending (mostly on roads) accounted for 12 percent. Nearly 19 percent of the non-debt budget went to security services, including the military's current spending budget and the police. Central administration, including foreign affairs and the judicial system, accounted for the other 9 percent. The administration's original 1994 budget plans envisioned an expansionary 38 percent nominal increase in central government non-debt expenditure, including a 62 percent jump in infrastructure spending. Those plans foundered when oil export prices fell below USD 10 per barrel in late 1993, forcing the government into another round of stabilization measures. Although the government was unable to secure an increase in the value-added tax from 10 percent to 18 percent, the December 1993 Internal Revenue Law created a minimum corporate income tax equivalent to 1 percent of assets, reformed the collection system, and set criminal penalties for tax evasion. After another month of delay, during which there was another spike in interest rates and drop in the sucre, in late January 1994 the government announced a 68 percent increase in official gasoline prices and implemented a new fuel pricing system. Since March 1994, the Finance Ministry has adjusted sucre fuel prices each month to reflect changing world prices of refined products, the sucre-dollar exchange rate, and compensate for lower than expected export crude prices. Government revenue from domestic fuel sales is expected to rise to 3.9 percent of GDP, up from 3.4 percent in 1993 and an average of 1.7 percent in 1991-1992. Telephone rates were increased in March 1994 and the government plans to replace the general subsidy on cooking gas with a program to help the poor later in the year. These measures made it possible for the government to reach an agreement with the IMF in March and set the stage for a settlement with commercial creditors in May (see Section III-D). In its 1994 economic program, the government plans to limit the consolidated fiscal deficit to 0.5 percent of GDP, including severance payments to another 20,000 laid-off public employees. To achieve the target, the government will need to maintain control over spending, increase public tariffs to compensate for inflation, earn an average of USD 13 per barrel for its crude oil exports, and achieve 3 percent economic growth. Real current expenditure will decline slightly to about 18 percent of GDP, while real capital expenditure will remain stable at about 7.3 percent of GDP. The government's 1993 performance and recent improvements in its ability to collect revenues and control spending suggest that the 1994 deficit goal can be achieved. Monetary Policy. With its priority on fiscal deficit reduction, the government has been less concerned by short-term control of monetary expansion. M1 (currency and demand deposits), increased by 49.4 percent during the 12 month period through December 1993, while M2 (M1 plus savings accounts and CDs) expanded by 51.6 percent. M1 expansion in 1993 was up 4.9 percentage points over 1992, but M2 was down by 4.5 points. Part of the reason for continued monetary expansion is the creation of sucres as dollars are repatriated to take advantage of relatively high interest rates and a stable exchange rate. The need to keep Ecuador's currency from appreciating has forced the Central Bank to periodically intervene in the market by selling sucres, which has increased foreign reserves, but generated upward pressure on the money supply. (See Part H for further information on foreign exchange policies.) The government has attempted to compensate for the inflationary effect of the foreign exchange influx by increasing its sucre deposits in the Central Bank. Meanwhile, although there have been fluctuations in interest rates, the resulting liquidity helped push rates on 90-day deposits down from 42 percent at the end of 1992 to 29 percent in December 1993 to a low of 24 percent in April 1994. Since late 1992 the Central Bank has attempted to regulate the money supply through a weekly auction of its own bonds and interventions in the secondary market to smooth out short-term fluctuations in liquidity. These market-based mechanisms replaced previous methods such as setting high reserve requirements, forced purchases of government bonds at fixed exchange rates, and interest rate controls. The current Monetary Regime Law, enacted in May 1992, substantially increased the independence of the Central Bank. By restricting the reserve bank's ability to extend credit to the government, state enterprises or the private sector, the law facilitated the elimination of inflationary financing of the public deficit. A proposed revision of the Monetary Regime Law would institutionalize the current policy of setting interest and exchange rates through the free market and further increase the Central Bank's ability to control the money supply through open market trading in government securities. Relations with International Financial Institutions. After failing to close an agreement with the International Monetary Fund (IMF) in mid-1993, the government carried out a second round of economic adjustment measures in early 1994 and finally concluded a two year stand-by arrangement with the IMF in March 1994. Although Ecuador failed to comply with the last IMF program signed by the Borja administration in December 1991, nearly two years of fiscal austerity under the Duran Ballen administration has restored some of government's credibility. Under the new IMF program, the Ecuadorian government has access to USD 184 million to support the balance of payments over the next two years. The IMF agreement also opens the door for greater World Bank and Interamerican Development Bank lending to finance economic reforms. Multilateral financing will also contribute to covering the upfront costs of the commercial debt settlement. - Principal Growth Sectors Petroleum and Mining. Crude oil production is currently running at 367,500 barrels per day, with most of the output coming from fields in the Oriente operated by Petroecuador, the state-owned oil company. The oil industry generates nearly 11 percent of GDP and forms the basis for Ecuador's external economy, through the export of two thirds of crude production; and public finances, through domestic sales refined products and export revenue. Total crude production for 1993 was 125.4 million barrels, of which 79.7 million barrels were exported, together with 9.6 million barrels of refined products. Production levels in 1993 were 7.1 percent above 1992. Exports of crude and derivatives earned USD 1,254 million, accounting for 43 percent of 1993 export earnings. Crude export volume was up 7.1 percent in 1993, but revenue was down 8.2 percent due to a weak international market that pushed the price of Ecuadorian "Shushufindi" light crude below USD 10 per barrel in late 1993. By June 1994, however, the price had recovered to USD 14.50 per barrel and production volume continues to increase. After years of low fixed domestic prices for petroleum products, in January 1994 the government introduced a market-related fuel pricing system. Annual crude oil production is projected to increase for the next few years as new fields are brought on line by state-owned Petroecuador and foreign contractors from the second generation of exploration in the Oriente. These new fields and the use of enhanced recovery techniques in established fields should offset declining production of Ecuador's current producing fields. However, production will peak in the late 1990's unless major new oil fields are discovered. Contract awards from Ecuador's seventh licensing round announced in June 1994 should result in more exploration activity over the next several years. Nevertheless, even if production levels can be maintained, growing local consumption may leave less oil for export. Moreover, foreign investor requirements for larger revenue shares, the lower quality of the heavy crude found in the newer fields, and increased spending on environmental protection should leave less income for the government. During the late 1980's, the government increased its control over the petroleum industry by terminating a joint-operating agreement with Texaco and assuming control of all privately owned facilities, including the Transecuadorian pipeline and two small refineries. Although the Borja government tried to encourage foreign investment through risk-service contract arrangements, no new exploration contracts were signed. In order to renew foreign investor interest in Ecuador's petroleum resources, Congress approved reforms to the Hydrocarbons Law in November 1993 to offer areas previously reserved for Petroecuador in a seventh licensing round, introduce a more investor-friendly production-sharing contract, and eliminate taxes on "excess" production. The new law also opens oil transport, refining, and marketing to private participation and permits the free import of petroleum products. In late 1994 the government is expected to award a USD 600 million concession to build and operate a second pipeline that will increase Ecuador's capacity to move crude oil to the coast from 325,000 to 450,000 barrels per day. Ecuador has extensive, but underdeveloped, mining potential, especially for gold. The sector only contributed 0.7 percent of GDP, but has been growing at a rate of 3 percent per year. Though production to date has been limited, with much of that lost to the black market, the value of recorded gold and silver exports tripled in 1993 to USD 59 million. Agriculture and Fishing. Ecuador is largely an agricultural country blessed with an abundance of rich, well-watered land and a mild climate. The peasant and commercial farmers of the Sierra mostly raise grains, vegetables, and livestock for domestic consumption. The region's agroexport potential is being developed through intensive cut flower and winter vegetable production. The coastal lowlands produce a variety of commodities for export, principally bananas, shrimp, coffee, and cocoa. Exports of high-value fruits such as melons, mangos, and pineapples is increasing. With the end of domestic price controls on rice, production is increasing to the point where Ecuador is expected to become a net exporter in 1994. Agriculture contributed 10 percent of Ecuador's GDP in 1993 and declined by 0.3 percent over 1992 due to a fall in the value of banana production. The main agricultural commodities accounted for 23 percent of Ecuador's exports in 1993, but declined in dollar export value by 15 percent. Bananas and shrimp, the mainstays of coastal agriculture, generated USD 503 million and USD 451 million respectively in foreign exchange in 1993. However, prospects for future growth are somewhat clouded. Ecuador is the world's leading banana producer, exporting 2.6 million metric tons in 1993, but growers are struggling to stop the spread of the black sigatoka fungus and maintain the volume, if not the value, of banana exports, while the government tries to reverse the European Union's protectionist banana import regime. Shrimp farmers must deal with the environmental stresses causing the "Taura syndrome" that leads to premature death of a large portion of pond shrimp. Meanwhile, cut flower production continues to expand and provide employment for rural people in the Sierra. Farmers are increasingly turning to other non-traditional, high value fruits and vegetables, while investments are being made in agricultural processing facilities. By increasing the security of rural property rights, the June 1994 Agrarian Development Law should promote greater investment in agriculture, provided the reforms are successfully implemented. The seafishing and aquaculture sectors declined by 8.3 percent in 1993 to make up 2.1 percent of GDP. Shrimp farming, fresh tuna, and other fishing accounted for 17 percent of 1993 exports and earned 14 percent less than in 1992. The export value of fresh and frozen fish, including tuna, declined by 11.6 percent to USD 48 million. Manufacturing, Construction and Utilities. Ecuador's industries have traditionally been divided among processors of primary exports (oil derivatives, cacao, coffee, fish) and producers for the domestic consumer market (food products, automobiles, textiles, pharmaceuticals). Over the past few years, import-substitution manufacturers have adjusted to a dramatic reduction in import duties that opened the Ecuadorian market to foreign competition. For example, the textile industry declined from 1990 to 1992, but grew by 1.3 percent in 1993. The important food processing sector only grew 1.2 percent in 1992, but production of wood, mineral, and mineral products expanded by 4.4, 6.2, and 4.9 percent respectively. The whole manufacturing sector (excluding oil refining) grew by 2.5 percent in 1993. Manufacturing accounted for nearly 22 percent of 1993 GDP. Manufactures made up 13.9 percent of exports in 1993, with earnings increasing by a dramatic 47 percent to pass USD 402 million. Export earnings from the metal manufacturing sector, primarily automobile assembly, increased over two and a half fold, while textile, chemicals and pharmaceuticals, and processed marine products all registered increases in the 40 to 60 percent range. Agricultural processing also grew, but at single digit rates. The liberalization of trade with Colombia and other members of the Andean Pact has helped Ecuadorian manufacturers find new export markets to off-set increased domestic competition. With the initial gains from trade having been realized and the real appreciation of the sucre making Ecuador's products more expensive abroad, export-led growth of manufacturing may slow during 1994. Construction activity fell for the fourth straight year, declining by 4 percent in 1993. The lack of increased public sector project spending will not help the construction sector in 1994, but recent increases in imports of construction materials may indicate a recovery in private construction. The public utility sector (electricity, gas, and water), which in the past has sometimes been a net drain on GDP due to high subsidies, grew by 2.1 percent in 1993, but did not make a significant contribution to GDP. Services. The private and public services sectors grew by 1.4 percent in 1993 to contribute 45 percent of GDP. With its natural, scenic and cultural attractions, Ecuador earned an estimated USD 200 million in foreign exchange from tourism in 1993. In spite of the rising dollar costs of vacationing in Ecuador, the number of visitors increase by 14 percent last year. Nevertheless, the tourism-dependent hotel and restaurant industry fell by 1.2 percent in real terms. Commerce, the largest service sector, grew by 2.1 percent. The communications sector continued to register strong growth, expanding by 8.3 percent due to infrastructure projects overseen by the state telephone company. Transportation increased by 2.7 percent. Financial services contribution to GDP boomed by 27.8 percent in 1993. Benefiting from capital inflows and high interest rate spreads, private banks increased their assets by 23 percent in inflation-adjusted terms. There was also an expansion in the number and assets of finance companies and brokerages. - Government Role in the Economy The Ecuadorian economy is largely owned and managed by the private sector, but the state has long played a significant economic role. In the past that role has included excessive bureaucratic regulation, generally unproductive subsidies for urban interests, and state ownership of economic assets in designated strategic sectors. The central government budget is about 15 percent of GDP, while total public sector expenditure has remained below 30 percent in recent years. About one third of the formal sector work force is employed by the central government. In recent years, a broad consensus has developed in favor of modernizing the state through a reduction in its role as a player in and controller of the economy, while strengthening its ability to effectively finance and deliver needed social services and enforce the economic rules of the game. Structural Reform and Privatization. Ecuador has been slow in embracing the market-oriented economic reforms taking place elsewhere in Latin America. During the 1988-1992 center-left Borja administration, such structural changes were not a high priority, although there was some progress on trade liberalization and monetary policy reforms. After an election campaign in which both major candidates campaigned on free market platforms, President Sixto Duran Ballen took office in 1992 promising a modernization of the Ecuadorian state. While the government has been successful on the stabilization front, the more fundamental structural changes required to improve the investment climate and prospects for long term growth has proven more difficult to achieve. Uneven relations with Congress, where the government parties are in the minority, delayed the administration's legislative agenda. The Modernization of the State Law, the center piece of the administration's program, sat in Congress for most of 1993 before a less ambitious version was finally enacted in December. Instead of giving the government broad authority to privatize the "strategic sectors" of the economy, including petroleum, electricity, and telecommunications, the final version only allows private sector participation in those sectors on a concession basis and generally relegates privatization to a last resort. The Modernization Law also provided for the decentralization of some government powers and facilitates reductions in the public sector work force. Although initial efforts to directly privatize parts of the petroleum sector were abandoned, the 1993 Hydrocarbons Law allows substantially more private participation in the industry (see Part B). A mechanism for privatizing shares in private companies held by state financial institutions was established with the May 1993 passage of the Capital Markets Law. Since then, the Quito and Guayaquil exchanges have been developing deeper quity markets where company stocks are traded (see Section VII-A9). However, beyond the sale of shares in a cement plant, the government was slow to utilize the markets to divest state holdings in commercial enterprises. A fertilizer company was sold directly to a local investor group. Ecuatoriana, the bankrupt state-owned airline, was transformed into a stock company, but has few assets left to privatize. There have been no proposals to privatize military-run companies, such as the TRANSNAVE and FLOPEC shipping lines or TAME airlines, or sell shares in private firms owned by the army's DINE holding company. In recent months, however, the modernization process has been rejuvinated as the administration moved to more fully embrace its own agenda. In March 1994, the president nullified hundreds of regulations interfering with the operation of the free market. The March 31 letter of intent to the IMF recommitted the government to privatization and restructuring of the public sector. In April 1994 the president appointed an activist chairman to head the previously moribund Modernization Council (CONAM). In May, a new financial institutions law was passed that opens up the banking system (see Section VIII-A). A controversial agrarian law was passed in June that liberalizes the markets for land and agricultural products. Legislation to allow the partial privatization of the telecommunications and electricity sectors has been submitted to Congress. The establishment of private pension funds is also a priority, although it has met with stiff opposition from the Social Security Institute employees union. Of even greater long term significance, discussion has started about the need to overhaul the deteriorating educational system in order to provide Ecuadorians with the skills needed to compete in the global economy. While it remains to be seen whether the Duran Ballen administration will be able to fully implement its modernization program, significant steps have been taken toward resolving Ecuador's systemic economic problems. Industrial Policies. The corporate tax rate is 25 percent on net income, with a minimum tax based on 1 percent of gross assets. The government is interested in negotiating a double taxation agreement with the United States. The Ecuadorian government has largely abandoned earlier industrial promotion policies characterized by tax breaks, subsidized credit, and protection from foreign competition. General industrial development tax deductions will be phased out in 1994. There are still some tax incentives for investment in fishing industry and the new agrarian law creates new incentives for agroindustry investment. Free trade zones and "maquila" procedures allow companies to import goods duty-free for processing and re-export. - Balance of Payments Situation Merchandise Trade. In contrast to the strong export performance and weak demand for imports that characterized 1992, Ecuador's external sector came under pressure in 1993. Revenue last year from foreign sales of crude oil, bananas, shrimp, and fish, which together account for 74 percent of Ecuador's export earnings, was 11 percent below that of 1992. Fortunately, strong earnings by the manufacturing (especially automobiles) and mining (mainly gold) sectors, as well as increased export revenue from flowers, cacao, coffee, and some non-traditional crops limited the drop in total merchandise export income to 3.5 percent to earn USD 2,903 million. Meanwhile, import demand recovered from an austerity-induced slump in 1992, increasing by 12.5 percent on a FOB basis to USD 2,223 million. (Note, however, that due to contraband imports and customs inefficiencies, Ecuadorian import data are substantially below what supplier country data would suggest. After balance of payments adjustments, the Central Bank estimates 1993 imports reached USD 2,325 million.) Consumer goods imports exploded by over 50 percent due to the effects of the real appreciation of the sucre and lower tariffs. Industrial inputs only rose 4 percent, but industrial capital goods rose by 22 percent by value while falling in volume. Inputs and capital goods imports for agriculture fell by 26 and 12 percent respectively, reflecting problems in the agroexport sector. With exports falling and imports rising, Ecuador's trade surplus shrank by 40 percent to USD 578 million in 1993, after having increased by 49 percent in 1992. Meanwhile, the services deficit remained stable at USD 1,068 million, due in part to continued low international interest rates for Ecuador's external debt. Thus, the falling trade surplus was responsible for the change in Ecuador's current account from a USD 10 million surplus in 1992 to a USD 641 million deficit in 1993. The United States is both the primary market for Ecuadorian exports and the key supplier of Ecuador's import needs. According to Central Bank data, Americans purchased 46 percent of Ecuador's exports in 1993, worth USD 1,327 million, down 5.7 percent from 1992. (However, U.S. Department of Commerce data put 1993 Ecuadorian exports to the U.S. at USD 1,399, up 5.1 percent over 1992.) Ecuador's main exports to U.S. include crude petroleum and non-crude oil, shrimp, bananas, coffee, gold, cocoa beans, tuna and other prepared fish, and cut flowers. After jumping by 29 percent in 1991 due to liberalization of Ecuador's trade policies, U.S. merchandise exports to Ecuador rose 8.2 percent in 1992 and a more modest 1.3 percent in 1993. Last year, according to Ecuadorian data, purchases from the U.S. reached USD 824 million on a CIF basis, comprising 32 percent of Ecuador's total CIF imports. (According to U.S. data, in 1993 Ecuador imported USD 1,098 million worth of U.S. goods on a FAS basis, up 9.9 percent over 1992 levels.) Major American sales to Ecuador last year included chemical products and pesticides, automobiles and trucks, wheat, semifinished iron and steel goods, pumps, computer equipment, heavy construction equipment, and motor parts. Ecuador faces a difficult balance of payments situation in 1994. During the first quarter of the year, Ecuadorian FOB exports dropped another 4.7 percent compared to the same period in 1993. Last year's pattern continued, with petroleum, bananas, shrimp, and fresh fish continuing their earnings slide, while coffee, cacao, flowers, gold, and manufactures brought in more revenue. With oil export volumes continuing the expand, however, second quarter improvements in export prices will raise export revenue considerably. Ecuador is increasing its banana export volumes, but the shrimp industry may be in trouble due to environmental problems. The deepening of Andean economic integration will continue to provide export opportunities for manufactures. Meanwhile, first quarter FOB imports are up 23 percent due to substantial increases in purchases of consumer durables, along with industrial inputs and capital goods. Agricultural inputs and capital goods are up to a lesser extent, while non-durable consumer goods are down. Capital Account. An inflow of private capital helped reduced Ecuador's capital account deficit to USD 123 million in 1993. Since late 1992, Ecuadorian flight capital has been coming back home to take advantage of interest rates that averaged 16 points above U.S. levels after allowing for sucre devaluation. The inflow of direct investment increased by 21 percent (from a low base) to USD 115 million in 1993, while external lending to the Ecuadorian private sector (the principal form of flight capital repatriation) more than tripled to USD 486 million. As in previous years, the capital account deficit was covered by mounting arrearages on the foreign debt, including interest arrears of USD 319 million and unpaid government debt principal amounting to USD 636 million, 54 percent more than the arrearages in 1992. A net inflow of capital amounting to USD 832 million has contributed to a real appreciation of the sucre, making imports more competitive and putting Ecuadorian exporters in a squeeze between rising sucre costs and stagnant sucre earnings. Due to the foreign debt agreement, Ecuador will not be able to cover a capital account deficit with arrears in 1994, but significant inflows of new funds from multilateral development banks and perhaps increased foreign investment should provide some compensation. Ecuador's net foreign exchange reserves at the end of 1993 stood at USD 1,254 million or enough to cover 6.5 months of imports, up from a low of USD 224 million when the Duran Ballen administration took office in August 1992 and USD 782 million at the end of 1992. Foreign reserves reached USD 1,280 million at the end of April 1994 and are projected to reach USD 1,529 million by the end of the year minus whatever reserves are used to finance the commercial bank settlement. The potential inflationary impact of the foreign exchange influx was muted by a 53 percent increase in government sucre deposits in the Central Bank during 1993. During the first third of 1994, government deposits only increased by 9.3 percent. External Debt. After running arrears on its commercial bank debt for seven years, Ecuador achieved a major breakthrough by coming to an agreement with the banks on a comprehensive debt restructuring agreement in May 1994. Due in large part to excessive borrowing during the oil boom of the 1970's and weak economic performance in the 1980's, the Central Bank's measure of the total external public debt stock grew to USD 12,800 million or about 94 percent of annual GDP by the end of 1993 and up USD 678 million from 1992 levels. Of that, USD 2,367 million corresponded to interest arrears, not counting interest on past-due interest. Due to economic and political difficulties later compounded by a break in the oil pipeline, the Febres Cordero administration stopped paying any debt service to commercial banks in January 1987. From June 1989 the Borja administration paid about 30 percent of interest due to some of its creditors while conducting sporadic negotiations with the foreign banks. Partial interest payments were suspended from September 1992 until May 1994 while the Duran Ballen administration made a renewed effort to negotiate a restructuring agreement. Scheduled debt service payments (principal and interest on both public and private debt) for 1993 amounted to USD 1,992 million or 56 percent of the value of the country's exports of goods and services, nearly half of which was financed by running arrears. Negotiations with commercial bank creditors resumed in earnest in October 1993, leading to a May 1994 agreement to restructure USD 4,454 million in principal and about USD 3,500 million in past-due interest owed to foreign commercial banks and secondary market investors in bank paper through the end of 1994. The agreement follows the outline of the Brady Plan, with creditors choosing whether to exchange current debt principal for bonds carrying a 45 percent discount or for full value (par) bonds carrying fixed interest rates of not more than 5 percent. Ecuador will pay past-due interest in full, although the amount will be recalculated at favorable rates, reducing the face amount by 21 percent, and interest payments will be partially capitalized for the first 6 years. Interest payments in 1994 will amount to USD 135 million. The agreement has been favorably received by the market. Assuming half of the debt stock is transformed into discount bonds, the Ecuadorian government will have to pay USD 558 million to purchase collateral for its new debt instruments, to be financed by multilateral lenders and government foreign exchange reserves. The agreement should reduce Ecuador's foreign debt at the end of 1994 by about USD 1.9 billion. Annual service payments on the government's commercial debt will run about USD 277 million or 1.7 percent of GDP through the year 2000, after which service costs will rise. Ecuador is largely current on official bilateral and multilateral debt, although the government has been running arrears in recent months. Ecuador's bilateral debt amounts to about USD 1,179 million, including USD 224 million owed to the U.S. Government as of the end of September 1993. Under five agreements with the Paris Club (official bilateral creditors) Ecuador rescheduled debt obligations contracted before 1983 that fell due through 1992. In June 1994, the Paris Club agreed to a sixth rescheduling covering USD 205 million in debt service payments falling due in 1994. - Trade and Investment Barriers Trade Policy. Ecuador is relative open to U.S. exports and direct investment. The old highly protectionist tariff system, a product of the import-substitution model adopted in the 1960's, was replaced by the Borja administration in 1991 with a simplified structure that lowered most tariff duties and fees to 5 to 20 percent of import value. The Duran Ballen government has taken a number of important steps to further liberalize trade and investment policy. Since September 1992 importers have been able to purchase foreign exchange on the free market, a right extended to exporters three months later. In January 1993, restrictive import licensing for agricultural products, inputs and machinery were eliminated. A special 2 percent import fee was incorporated into the tariff structure in March 1994. On the export side, levies on agricultural commodities were abandoned in December 1993 and official port charges were reduced by 25 percent in January 1994. Investment regulations issued in January 1993 provided full national treatment for U.S. and other foreign investors and opened the way for the signing of a bilateral investment treaty with the U.S. that provides for free transfers and binding arbitration dispute settlement procedure. Most economic sectors are open to foreign investment without prior government approval and tax surcharges on remittances have been eliminated. Improvements have been made to Ecuador's intellectual property rights regime. (See Section VII for more information on the investment climate.) The Ecuadorian government has been pursuing trade liberalization agreements on both regional and global levels. A bilateral free trade agreement with Colombia that went into effect in October 1992 helped generate a 44 percent increase in trade between the two countries in 1993. Similar agreements are in effect with Venezuela and Bolivia. In 1994 Ecuador is expected to implement a common external tariff regime with fellow Andean Pact members Colombian and Venezuela that should cover most imports. The Ecuadorian government has also expressed an interest in joining a Mexico-Colombia-Venezuela or "G-3" trade accord. On the global level, Ecuador applied to join the General Treaty on Tariffs and Trade (GATT) in September 1992 and is currently negotiating with its major trade partners on the terms of accession. Most Ecuadorian products enjoy duty-free access to the U.S. market under the Andean Trade Preferences Act (ATPA) or the Generalized System of Preferences (GSP). Ecuador does not currently have any export subsidy programs. Customs Procedures and Tariff Levels. Ecuadorian customs procedures can be difficult, but are not generally used to discriminate against U.S. products. A new Customs Service Law was enacted in March 1994, together with a service privatization provision in the December 1993 tax reform law, should facilitate the creation of a modern, and less corrupt, customs system. Instead of customs officials physically inspecting all incoming merchandise and determining duties, as of July 1994, importers will submit declarations and inspections will be limited to random checks or as part of an investigation. Computerization of customs records should further speed up the process. The corrupt Military Customs Police has been replaced by a small guard service that is not protected by military law. The government may contract with private businesses to perform many customs functions. Ecuador's tariff schedule is based on the Harmonized System of Nomenclature. Consistent with the Andean Pact common external tariff, the highest duty, 37 percent, is levied on automobile imports to protect the local assembly industry. Most consumer goods imports pay 20 percent, while intermediate goods are usually imported at the 10 or 15 percent rates. Raw materials and capital goods generally pay 0 or 5 percent. Ecuador has negotiated exemptions under the common tariff that allow for lower duties for certain capital goods and industrial inputs. The new agrarian law provides for duty-free import of agricultural inputs and equipment. All imports are also subject to a 1 percent customs fee and the 10 percent value added tax. Importers must obtain prior import licenses from the Central Bank, which are usually made available for all goods, although importers sometimes encounter bureaucratic delays. Government Procurement. Government procurement practices do not usually discriminate against U.S. or other foreign suppliers. However, bidding for government contracts can be cumbersome and competitors from other countries do not operate under the restrictions of the U.S. Foreign Corrupt Practices Act. The government's requirement for a bank-issued guarantee to ensure execution of the contract presents a problem for some bidders. Shipments to Ecuadorian government agencies no longer have to be made via Ecuadorian flag vessels or airlines. Residual Trade Barriers. In spite of the dramatic liberalization in Ecuadorian trade policies, some residual non-tariff and customs procedure barriers exist that impact on U.S. exporters. A 1976 law prevents U.S. and other foreign suppliers from terminating existing exclusive distributorship arrangements without paying compensation. In September 1993, non-transparent sanitary requirements were imposed on imported processed foods, as well as some other consumption goods, which have had the effect of blocking the entry of some imports from the U.S. In an effort to slow imports of textiles and apparel from the Far East, the Ecuadorian government began setting minimum prices for calculating textile duties in 1993. A minimum price has also been set for beer imports. In January 1993, Ecuador adopted a system of price band tariff surcharges in order to stabilize prices of certain agricultural products, particularly on poultry and wheat, which may affect U.S. sales. In its letter of intent to the IMF, the government indicated that it will review both the minimum customs value and price band mechanisms to ensure that they do not constitute barriers to trade. - Labor Force Work Force Structure and Education. Ecuador's population will reach an estimated 11.22 million in 1994, of which 3.67 million are economically active. About 45 percent of the population is urbanized. Members of indigenous communities, many of whom speak Quichua as their first language, make up over a quarter of the population and are largely dependent on peasant agriculture. In the urban and semi-urban areas there are 2.3 million economically active people, with about 980,000 of them holding formal sector jobs. A similar number, some 41 percent of the urban workforce, earn their living in the urban informal sector, demonstrating that while Ecuador enjoys a wealth of entrepreneurial talent, it still lacks the legal structures and economic opportunities needed for a more rapid expansion of the modern economy. With the country experiencing a growth recession in 1993, open urban unemployment was measured in November 1993 at 9.4 percent, up from 8.9 percent in a July 1992 survey. Formal sector underemployment runs about 7 percent. Thanks to an extensive education system, Ecuadorians have a Spanish literacy rate of 86 percent. Workers with vocational and artisan skills are relatively abundant at low wages. However, educational quality at the university level has suffered a significant decline over the past three decades due to overexpansion, politicization of university governance, falling academic standards, and fewer public resources. The resulting decline in teacher quality, compounded by the falling real incomes of teachers, has led to a deterioration of public education at the primary and secondary levels as well. Upper level Ecuadorian managers today have frequently received their education abroad, most often in the United States. Although the issue of educational reform is widely discussed, the government has yet to make it a part of its modernization program. Wage Levels. Minimum wages are set by the Ministry of Labor every six months according to job and industry and can be adjusted by Congress. The lowest minimum monthly compensation standard, including mandated bonuses but not social security deductions or transport allowances, set at the sucre equivalent of USD 93 per month in January 1994, deteriorated due to inflation and sucre devaluation to USD 88 by June, and was raised 34 percent in nominal terms to 258,789 sucres or USD 118 in July. The Duran Ballen administration has proposed a modest simplification of the complex minimum wage and bonus system. The minority of workers fortunate enough to hold jobs in the modern private sector and state enterprises usually receive substantially better salaries and extensive benefits. In the past two years, private sector professional salaries have generally been rising in dollar terms. Employees of the government ministries, have seen their effective pay substantially eroded by inflation in recent years. As of June 1994, lower level civil servants earned USD 138-217 per month, while managers and senior professional staff earned USD 320-816 per month, including housing and representational allowances. Conditions of Employment and Unionization. The labor code provides for a 40 hour work week, 15 calendar days of annual paid vacation, restrictions on child labor, general protections of worker health and safety, a minimum wage, and employer-provided benefits such as uniforms and training opportunities. Pregnant women are entitled to 12 weeks of maternity leave of absence. Companies are required to distribute at least 15 percent of pre-tax profits to their employees. Job tenure rules make it difficult and expensive to lay-off permanent workers. Revisions to the labor code in 1991 reduced indemnity payments and allowed more flexible working arrangements. Despite the reforms, employers consider the labor code to be highly unfavorable to investment and a disincentive to hiring union members and to expanding employment in general. U.S. companies are subject to the same rules and regulations on labor and employment practices governing basic worker rights as Ecuadorian companies. Under the Ecuadorian constitution, most workers in the private and parastatal sectors enjoy the right to form trade unions. The revised labor code raised the number of workers required for an establishment to be unionized to 30. Less than 10 percent of the urban workforce, mostly skilled workers in medium to large sized private or state industries, are officially organized. The 1990 in-bond export processing ("maquila") law permits the hiring of temporary workers in maquila industries, effectively limiting unionization in the sector. Private employers are required to engage in collective bargaining with recognized unions. The labor code provides for resolution of conflicts through a tripartite arbitration and conciliation board process. The code also prohibits discrimination against unions and requires that employers provide space for union activities. Except for public servants and workers in some parastatals, workers by law have the right to strike. Legally striking employees are entitled to full pay and benefits and may occupy the premises under police protection. Restrictions on solidarity strikes were imposed in 1991. Most public sector employees are technically prevented from joining unions, but most are members in a labor organization. As the national teachers' strike of October 1993 to January 1994 demonstrated, illegal strikes by public employees are tolerated. Although trade union political influence has declined in recent years, the Unified Workers Front (FUT) and various labor federations occasionally attempt to stage national strikes to protest the modernization process and economic adjustment measures. In 1993 there were no strikes or serious labor problems in any U.S. subsidiary. - Infrrastructure Situation Transportation. The two international airports in Quito and Guayaquil are serviced by several major carriers, including American and Continental and several U.S. air cargo companies. Ecuador's Saeta and Tame airlines also provide connections within the country. Increasing passenger and cargo congestion will require expansion of current airport facilities or possibly the construction of new airports within the next five years. The containerized port of Guayaquil handles most of the country's imports and exports. The port is fully utilized, with ship turn arounds typically taking five days. The main oil terminal is located at Esmeraldas on the north coast. On the central coast, Manta has traditionally handled much of Ecuador's cacao and coffee exports and is currently only utilized at half capacity. Machala's Puerto Bolivar on the south coast is the major banana port. Modernization of procedures under the new customs law and privatization of cargo services should help improve the efficiency of Ecuador's ports. Port fees were recently reduced by 25 percent. Ecuador has an extensive system of all-weather roads linking all populated parts of the country. While there are plans for expanding the road system in sparsely populated Oriente and northwest coast regions, maintenance and widening of existing roadways is of greater urgency. Subsidized inexpensive urban, intercity, and rural bus service is available throughout the country. Trucking companies move almost all of the in-country freight, although goods must still be moved to national carriers when crossing the border with other members of the Andean Pact. The railroad system has been largely inoperative for the past decade and will require extensive reconditioning and investment to become a viable transportation alternative. Telecommunications and Electric Power. Telecommunications services are provided by EMETEL, the state-owned telephone company. Domestic and international direct dialing is available, with income from the latter going to subsidize the former. Very low domestic rates were increased substantially in March 1994. Service continues to be rather poor and there are still only about 4 telephones per 100 people. Many calls are not completed. Obtaining new telephone lines is expensive and time-consuming. Two private concessions providing cellular telephone services began operating in 1994. Long distance call-back services are becoming more widely used. The government has introduced legislation to allow private companies to provide local and long distance telephone services on a concession basis. It is likely that separate concessions will be granted for the Quito and Guayaquil regions. Ecuador has an available electricity generating capacity of about 1700 megawatts. Hydroelectric power plants operated by the state-owned INECEL utility, including the 500 megawatt Paute project, account for over half of installed capacity and supply three quarters of the country's current needs. Supplemental thermal power is often required during the dry season, particularly in drought years. Since September 1992, the government has moved away from the practice of making electricity available at highly subsidized rates. Several distribution companies owned jointly by INECEL and local municipalities transmit power to consumers. One private firm, EMELEC, provides distribution and back-up generating services in Guayaquil. Proposed reform legislation would enable the private sector to build additional generation capacity on a build-operate-transfer basis and distribution company shares may be privatized. Although there are no plans to sell assets, private companies may be brought in to run existing generating plants. There is currently no market for natural gas in Ecuador, although that could change with the development of gas fields in the Gulf of Guayaquil. Liquified petroleum gas (LPG) is the most common cooking fuel, although that could also change if the government reduces subsidies later in 1994. Water and Irrigation. Ecuador's surface and subsurface water resources were nationalized by the Water Law of 1972. Urban water supplies are provided by municipality-owned water utilities. The central government heavily subsidizes water and sewer system development through the Ecuadorian Sanitary Works Institute (IEOS). The Hydrological Resources Institute (INERHI) is responsible for water management and irrigation projects and must approve all transfers of water rights. Several large scale highly-subsidized flood control and irrigation schemes are run by regional bodies such as the CEDEGE in the Guayas basin, the CRM in Manabi, and the CREA and PREDESUR in the southern part of the country. - Major Infrastructure Projects Second Transandean Pipeline Project: Petroecuador, the Ecuadorian state petroleum corporation, has called for bids for the construction and operation of the Ecuadorian Transandean pipeline. This is the biggest project in Ecuador's history and is expected to cost USD 500-600 million. The new pipeline is to run some 300 miles from Ecuador's Amazon jungles over the Andes to the Pacific port of Esmeraldas. It will have a capacity of 125,000 barrels per day (bpd). The winner will be awarded a concession contract in which it will have to finance, build, and operate the pipeline for a specific period of time. The project is estimated to take 24-36 months to complete. Occidental Engineering Services Company and Enron are leading U.S. consortia in pursuit of the contract. The bid deadline is September 27, 1994. Expansion of the Esmeraldas Refinery: Petroindustrial, a subsidiary of Petroecuador, the state petroleum company, has called for firms to expand the Esmeraldas refinery's capacity from 90,000 bpd to 110,000 bpd. The project also includes modifying the refinery to process heavier crude. The project is expected to cost USD 130 million. M.W. Kellog, Raytheon Engineers & Constructors, and ABB/Lummus have prequalified. Bids are expected to be called at by the end of July 1994. New Airports for Quito and Guayaquil: The Ecuadorian Government plans to construct two new airports, one for Quito and another for Guayaquil under a concession regime with a foreign private consortia. The consortia would finance, build and operate the airports for a fixed period of time. The project is expected to cost USD 460 million. Groups led by Raytheon International Company and Hughes Airport Systems have shown interest in this project. An international call for bids is expected to be announced sometime in 1994. Daule-Peripa Hydroelectric Plant: CEDEGE (Commission for the Development of the Guayas River), plans to call for bids for a 25 year concession to build, finance and operate a 130 megawatt hydroelectric power plant at the Daule Peripa dam. The project is expected to cost USD 120 million. An international call for bids is expected in July-August 1994. No U.S. companies are known to be involved at this time.