Ecuador's winning strategy

Ecuador has bought back—at 35% of face value—some 91% of its defaulted foreign bonds, in a transaction that was more successful than the government, and many analysts, thought possible. The repurchase, despite the huge discount, was relatively well received by the market, with few holdouts—and even these will be given another chance at a deal in the near future. The buyback represents a rare instance of a country that did not repay its debt even though it had the resources to do so. It was also one of the least contentious in the history of Latin American sovereign defaults.

The government of President Rafael Correa stopped payments on Ecuador's Global 2012 and 2030 bonds last December, but not directly because of financial difficulties. Indeed, the oil-exporting country had sufficient reserves to remain current on its debt obligations. However, a government commission charged with auditing the country's foreign debt ruled that the initial negotiation process for contracting the debt in 2000 (the bonds were a restructuring and repackaging of previously existing debt) was riddled with irregularities and therefore the bonds were “illegitimate”. The bonds involved total US$3.2bn in value.

The debt repurchase began in late April with a modified Dutch auction, where bondholders could make bids at or above the suggested price (30 cents on the dollar). After the tender of bids, the finance minister, María Elsa Viteri, announced in late May that the government would repurchase the bonds at 35 cents on the dollar and offered bondholders who had bid above the clearance price the opportunity to submit revised offers until June 3rd in an effort to keep holdouts to a minimum.

According to Ms Viteri, the increase in the minimum buyback price was a natural response of the auction mechanism and she warned bondholders against holding out, suggesting that Ecuador would offer an even lower repurchase price if they did not accept the initial discount.

Some government flexibility

Ms Viteri had expected the auction would retire at least 75% of the bonds. Her expectations were exceeded, as the government announced on June 12th that 91% of the total in defaulted bonds was retired, amounting to one-third of Ecuador's total foreign debt. The government paid some US$900m for US$2.9bn in bonds.

The successful repurchase highlighted a gradual softening of the government's position since the default in December. The financial authorities appear to have come to the realisation that even if they disagreed with how the debt was negotiated, the government had a responsibility to try to solve the problem. The final objective of the buyback process was to retire as much debt from the market as possible. As a result, the government will save approximately US$300m a year on interest payments, according to President Correa.

Completion of the buyback operation could also signal the government's recognition that it will need more financing to compensate for the reduction in fiscal revenue owing to the global economic crisis and lower oil prices. Although oil prices have risen recently, the public finances are still on shaky ground and further financing is being sought.

The market's acceptance of the buyback also was reflected in the price movements of Ecuador's 2015 Global bonds, which the government still considers legitimate. The price on these initially rose by six percentage points in response to the auction results.

Fortuitous timing

According to analysts, Ecuador's success is attributable to various factors. First, although Mr Correa included debt repudiation as part of his policy platform when he took office in January 2007, he waited two years before taking action. Thus the default came amid the global financial crisis, with many institutional investors and other holders of Ecuador's debt under pressure to liquidate their assets.

Second, the government used a large local bank, Banco del Pacífico, to start buying the defaulted bonds in the open market at levels above 20 cents on the dollar (some local analysts believe that as much as 50% of the defaulted bonds may have been purchased in this manner). That was just high enough of a price so that vulture investors were unwilling to take a large position in the instruments. Third, Ecuador offered to pay cash rather than try to do a bond-for-bond swap, and thereby avoided needing to go through a lengthy regulatory registration process.

Finally, it did not propose a take-it-or-leave-it transaction, as was the case with the highly contentious Argentinian debt exchange in 2005. Instead, bondholders were allowed to offer a price at an auction.

Risks still remain, however, for both creditors and the government, despite the Correa administration's apparent winning strategy. For one, the relatively smooth default and repurchase could encourage the government to default on the 2015 bonds if its fiscal situation worsens. Moreover, the administration may also potentially seek to restructure its bilateral (US$1.4bn) and multilateral (US$4.3bn) debt.

There is also a chance that those who did not participate in the auction will seek repayment via lawsuits aimed at seizing Ecuador's assets abroad, including oil shipments, rather than accepting the government's offer to repurchase the outstanding bonds at a later date (although the as-yet-unresolved situation of the Argentina holdouts could well discourage them.) Until there is a solution to these holdouts, Ecuador will remain locked out of voluntary capital markets, despite the market's acceptance of what one analyst has called “an elegant restructuring”.