Does Ecuador's Default Foreshadow the Next Latin American Debt Crisis?

December 18, 2008 11:45 AM

It should come as no surprise that Ecuador has become the first Latin American country—and the second country after the Seychelles—to default on its debt since the start of the current financial crisis. In market terms the default, which occurred on December 12, is not a big deal. Ecuador's debt totals no more than $3.9 billion—compare this to Argentina's 2002 default of $100 billion. Also, Ecuador's was not a case of insolvency or illiquidity. Instead, Ecuador declared itself unwilling to pay, citing the "illegitimacy" of the debt, which had been issued by previous administrations.

When Latin American countries default on their debt, however, people take notice. Latin America has had an illustrious association with great debt crises. The beginning of the 1930s debt crisis was marked in 1931 with defaults by every Latin American country (barring Argentina). This phenomenon quickly spread to Southern and Eastern Europe. Half a century later, in the summer of 1982, Mexico announced that it would not be able to service its debt. This triggered the Latin American debt crisis and plunged the region into what has become known as the "lost decade" of the 1980s.

Should we worry about Ecuador's default? Not really—and yes.

Latin American countries' macroeconomic fundamentals are, on the whole, much stronger than they were in the early 1980s. For the most part, the region has conquered inflation and stemmed the extreme exchange rate volatility that plagued it in decades past. Most countries have budgets that are in balance or even in surplus. External debt is much lower than it was in the mid-1980s, averaging 26 percent of gross national income (GNI) for the region in 2006 versus 45 percent in 1982 or 62 percent in 1987.

Ecuador has also followed different policies from those of many of its neighbors. While most other Latin American countries have increased their integration into the international system, Ecuador has lagged behind. The Latin American region has expanded its share of trade in GDP from 32 percent in 1990 to 48 percent in 2007. Although highly dependent on trade—as well as oil, Ecuador is a significant exporter of shrimp, bananas, and cut flowers—Ecuador has not participated actively in the network of trade negotiations that have engaged neighbors such as Chile and Peru.

The other country whose openness to trade has not increased—in fact, openness has fallen from 60 percent to 48 percent—is another Andean country: Venezuela. Ecuador's recent policies—expelling the World Bank representative from its territory, for example—also have more in common with those of Venezuela and Bolivia than with those of most other Latin American countries.

It is important to note that Ecuador's default is not based on an inability to pay: Ecuador has $5.6 billion in reserves and a debt-to-GDP ratio of only 33 percent. It is unlikely that investors, at least those who pay attention, will confuse Ecuador with Chile or Peru or Brazil. In the end, Ecuador's private sector will bear the brunt of this decision, as access to credit and trade finance dries up and supply chains are disrupted.

However, these factors should not lead to complacency about the dangers that Ecuador's default poses for the rest of the region. A troubling aspect of Ecuador's default is the possibility that other countries that disagree with previous governments' policies or that oppose the capitalist system may be inclined to follow suit. A second troubling aspect is the signal that this default sends to international creditors and investors about the region. In a time of low confidence, dropping commodity prices, and already squeezed credit markets, such a black mark may complicate matters for the region.

Latin American countries have ridden the commodity boom well and have followed sensible macroeconomic policies, accumulating reserves and building up their economic base. As of October 2008, Mexico had sufficient international reserves to buy imports for four months; and Brazil, for fourteen. However, these countries, like most Latin American countries, are commodity exporters largely dependent on trade with the OECD (the club of leading industrial nations) and with the formerly fast growing emerging markets, such as China and India. Access to trade finance is essential to their recovery. Most are facing economic difficulties not of their own making. The last thing they need is for their neighbors' actions to exacerbate their problems.

Will Ecuador's default lead to a new Latin American debt crisis? Likely not, but, if Ecuador's actions are a harbinger of further "ideological" defaults, it will certainly be a new challenge for an already troubled financial system.