Ecuador Binding Constraints to Growth I DB LAC Competitiveness & Growth Seminar

1. Ecuador Binding Constraints to GrowthIDB LAC Competitiveness & Growth Seminar Simon Cueva Vicente Albornoz Leopoldo Avellán September 2007

2. 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

3. An intermediate growth performer in the region Source: ECLAC • 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

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

5. GDM decision tree

6. 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 Source: Proyecto Salto survey

7. 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

8. 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

9. 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 Oil Production Energy Transmission and Distribution Losses Source: World Bank’s WDI, average includes Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Panama, Peru and Uruguay.

10. 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)

11. 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

12. 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

13. Micro risks & appropriability: the weakest link

14. 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

15. 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

16. 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%)

17. Product space and strategic value • 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

18. 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

19. 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?)

20. 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)