By
James McKeigue Mar 04, 2013
Moneyweek
You would have to be nuts to invest in Ecuador. Firebrand socialist
leader Rafael Correa has just secured another four-year term and vowed
to carry on his “citizens' revolution”. And so far, that revolution has
been a painful one for Western investors.
Since coming to power in 2007, Correa has voluntarily defaulted on the
country’s debt, rewritten terms for natural resource companies and
steadily pushed up taxes for imported goods.
Unsurprisingly, most multinationals have taken the hint and left the
country. Foreign direct investment now stands at less than 1% of GDP –
the lowest in the region apart from Venezuela.
But today, I want to tell you why I reckon that could be about to
change and throw up some exciting – though risky – investment
opportunities in the region.
First though, I must confess, I have something of a vested
interest in Ecuador. My fiancée is from the country and I’ll be getting
married over there in August.
That doesn’t make me automatically bullish on the country. After
all, landowners in the coastal region where my other half is from are
no great fans of Correa. Many are wary of his attempts to meddle in
agriculture.
Correa: two sides to the man
I have spent a fair bit of time in the country and I’ve seen
first-hand some of the unreported positive aspects of the Correa regime.
The most obvious is the road building programme.
Ecuador’s transport system was a mess when Correa came to power
and since then he’s built thousands of kilometres of road and
constructed massive new bridges. That’s helped to slash journey times
and cut costs for the country’s businesses. He’s also spent heavily on
schools and welfare payments.
Not all of this money has been well spent, and you could argue
that the latter was a calculated bid to buy voters. But either way, it’s
helped boost growth in the economy. In the last few years, Ecuador has
been one of the fastest-growing economies in the region, with GDP
averaging 6.7% since the start of 2011.
That economic growth, combined with shrewd political nous and
generous wealth transfers, helped Correa win last month’s election by a
landslide. He picked up 57% of the vote with his nearest rival
collecting just 24%.
So why, given Correa’s strong position, do I think that the
country has potential for British investors? Well for starters, Correa’s
situation is not as comfortable as it looks.
There are plenty of complaints about his meddling, authoritarian
style. Many in Ecuador are uneasy about his attempts to control the
media, while he often causes annoyance with his penchant for
micromanaging society.
For example, last year he produced a strange ruling that governed
how pupils at public schools could celebrate their Christmas parties.
There are also plenty of corruption scandals, examples of nepotism and a
supposed coup in 2010 that many suspect was faked.
Yet, as the elections demonstrated, the majority of the
population will overlook these issues as long as Correa continues to
spend heavily and deliver economic growth. And that’s why Correa, with
an economics PhD, may be nervous.
Over-reliance on oil – where to look now?
So far, he’s rejected the ‘Washington Consensus’ of free trade
and liberal economic policies and managed to carve out impressive growth
by doing things his own way.
His 2008 default cut Ecuador off from international debt markets
but he made up for this by negotiating oil finance deals with China. As a
result, he’s been able to almost double government spending and turn
Latin America’s lowest spending government into its highest.
As for the general economy, his anti-Western rhetoric and harsh
tax regimes scared off most foreign investors, leaving the country
increasingly dependent on the state-owned oil company and local
agricultural exporters. Fortunately for Correa, record commodity prices have helped both industries and the economy has continued to boom.
The trouble is, neither of these things can carry on
indefinitely. His government is dependent on oil, which accounts for 40%
of revenues. If oil remains flat or falls, as many analysts expect,
then Correa will struggle to maintain his largesse. When faced with this
problem in the past, Correa has turned to the Chinese but they won’t be
able to help him out forever.
According to leaked reports, it's estimated that Correa has
pledged 80% of Ecuador's state-controlled production until 2020 to
China. In other words, he is running out of stuff to offer the Chinese.
Oil is also very important to the wider economy, making up around
50% of exports. “Ecuador is running a current account deficit despite
the fact oil prices, and hence its terms of trade, are close to record
highs”, notes Michael Henderson at Capital Economics. “We estimate that
if global oil prices were to fall to below US$90/bbl, this would be
consistent with the current account deficit widening to over 5% of GDP.”
So if Correa wants to keep the economy growing and remain popular
with the voters, he needs to find another source of capital – and that
could be you. As unlikely as it sounds, Correa is starting to realise
that Western resource companies – owned by shareholders such as
yourselves – are his best chance of keeping growth going and staying
popular with the voters.
Ecuador is finally opening its arms, especially to miners
Thanks to Correa’s tough treatment, many oil firms have left the
country and production is stagnating. Now Ecuador is trying to fix that
by auctioning exploration rights in hitherto unexplored parts of the
country.
Given the understandable reluctance of international oil
companies, officials from the Hydrocarbons Secretariat of Ecuador (SHE)
are launching a worldwide charm offensive. They’re halfway through an
international roadshow that is stopping off in Colombia, the US, France,
Singapore and China.
It’s a remarkable turnaround for a country that has spent the
last four years fighting international investors. Indeed, Wilson Pástor,
minister of Ecuador’s Nonrenewable Natural Resources, admitted as much
when he launched the roadshow.
“We are beginning a new era of exploration in Ecuador. We have
not explored enough in the past 15 years, and it is time for Ecuador to
attract new foreign investment to move our industry and country forward
and to increase our reserves.”
Correa also seems keen to diversify away from an overdependence
on oil. Fortunately for him, Ecuador is rich in a wide range of natural
resources. One is agriculture. Just look closely at the label the next
time you buy a packet of shrimps or bananas from Tesco and odds on
they’ll be from Ecuador.
However, encouraging large-scale foreign investment in agriculture
would be politically disastrous. So instead, Correa is looking to push
investment in the untapped mining sector.
In the last few months, he’s made a number of high profile calls
to “make it easier” for mining companies. In February, he told Reuters
"I don't like mining, and open-pit is even worse, but it's impossible to
think of modern life without mining and it would be irresponsible not
to use those resources... They can be key to fight poverty.”
Given Correa’s previously hostile approach to miners it’s a
massive turnaround. More importantly, he’s backing up his words with
actions. Last year, he signed a contract with a Chinese miner for a
$1.6bn copper project. While just last month, Chilean state-controlled
miner Codelco received permission to start another major copper mine.
Meanwhile, Correa is currently pushing legislation through
Congress that will relax terms for miners. His aim is to water down the
existing framework – which includes a 70% windfall tax – so that he can
finally finalise a much-debated project with Canadian miner
Kinross (NYSE: KGC).
The proposed mine – known as Fruta del Norte – is one of the
world’s biggest remaining gold and silver deposits. According to Kinross
it contains 6.7 million ounces of proven and probable gold reserves
and nine million ounces of proven and probable silver reserves.
Negotiations have been going on for years and I am not going to bet
that they’ll be concluded successfully now. But while I can’t be sure if
this deal will happen it is clear that Ecuador’s mining sector is
hotting up.
Problems Correa will have to overcome
It won’t be easy. William Lee, the Ecuador analyst at the
Economist Intelligence Unit, told me that, while Correa may be talking
up investment, there still remains plenty of work to be done on the
ground.
Firstly, the regulatory structure has been adjusted so many times
that miners are bound to be nervous. Meanwhile the difficult business
environment and weak institutions will increase the cost of operations.
Another obstacle is opposition from environmentalists and
community groups who are worried that these projects will damage the
country.
Given the shocking environmental pollution caused by Western
companies in Ecuador in the past – these groups deserve to be listened
to. However, I actually think that opposition could work in the favour
of listed Western resource firms who – nowadays at least – are often the
best equipped and most inclined to take care of environmental issues.
The final thing to remember – as an Ecuadorian trade official pointed
out to me in a private conversation – is that “these companies are
active all over the world. Ecuador might be risky but many other
countries are a lot worse.” It’s not your typical sales pitch but it’s a
fair point. Especially when you consider the country’s massive
potential for gold, copper and oil projects.
I’ll be keeping a close eye on Ecuador’s resource sector in the
coming months and will update you on any exciting developments. Western
companies operating there are likely to trade at a discount – for
example Kinross’s on-going Ecuador debacle has hammered the share price –
which will create opportunities for brave investors.
