Politics versus economics, Ecuador-style

Written by Stephen Poloz

An oft-made assumption in country risk assessment is that economics generally rules — although politics can lead to emotional or even rash action, in the end people will act with their own economic interests at heart. But that assumption sometimes misses the big picture.

Recent events in Ecuador offer an interesting case study. In mid-August, residents in north-east Ecuador carried out a series of sophisticated protests against the country’s management of the oil industry. The protesters blocked roads, seized the region’s two main airports, occupied hundreds of oil wells and blew up a pipeline owned by a Canadian company. Oil production and exports, usually on the order of 500,000 barrels per day, were brought to a virtual standstill.

In response, the Ecuadorian government declared a state of emergency, granting the military special powers to restore calm. This took several days, but the protesters agreed to negotiate a settlement while oil production was being restored. That settlement will increase benefits to the local economy significantly.

Some risk analysts might have predicted that the citizens of a country like Ecuador would respect the country’s oil infrastructure given that it is so crucial to their standard of living. Oil accounts for 60% of Ecuador’s total export revenues, and 16% of GDP. Such arguments are often made to reassure foreign investors contemplating taking on such exposures.

But Ecuador illustrates how such reasoning can be faulty when few of the benefits of foreign investments trickle down to the general population and democracy is weak. Ecuador’s government is divided, and its willingness to act in heavy-handed fashion only fuels opposition. In effect, people use protests and violence as a substitute for conventional political processes.

And it has worked before. Back in 2002, inhabitants of the same region obstructed the construction of a pipeline in which there was again some Canadian participation. After the declaration of a state of emergency the locals successfully negotiated payments of millions of dollars from the oil companies and the government to fund local infrastructure investment.

From the point of view of the foreign investor, this process could amount to creeping expropriation — a gradual erosion of the value of their investment. In countries where political institutions are weak and the distribution of income is highly skewed, the risk of creeping expropriation is higher as foreign investors are forced to compensate for the government’s shortfalls.

The bottom line? Ecuador clearly presents a challenge for foreign investors. In future, foreign companies will need to demonstrate an even higher level of corporate social responsibility, with particular attention given to the local population, to mitigate the risk of creeping expropriation. And analysts should remember that politics can outweigh economics.

September 1, 2005

The views expressed here are those of the author, and not necessarily of Export Development Canada.

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