Ecuador on the Brink of Default? Audit Report Finds Illegalities Surrounding Foreign Debts

Ecuador's Audit Commission Finds `Illegality' in Debt (Update5), Bloomberg.com
Ecuador's Bonds Fall After Patino Says Government May Default, Bloomberg.com
Correa: Se tratará de no pagar deuda illegal, El Universo
Ecuador posterga pago de cupón de bono Global 2012, El Universal

Ecuador’s President Rafael Correa has threatened since his 2006 presidential campaign to default on various foreign debt obligations. Last year, Correa set up a debt audit commission to investigate the legitimacy and legality of certain public debts. Ecuador insists it is able to meet all of its foreign debt obligations, but will not pay “illegitimate debt.” This year on Nov. 15 Correa said he would suspend payments on certain bonds if the report provided a legal basis for such a move. With a report released by his government on November 20, those threats of default seem likely to become reality.

In its November 20 report, the audit commission announced it had uncovered “serious signs of illegality” regarding billions of dollars in public debt. The crux of the report was based on Ecuador’s three global bonds of approximately $3.9 billion USD. Ecuador issued the bonds in 2000 and they are due in 2012, 2015 and 2030. The 2012 and 2030 notes were the results of restructured debts from a previous default by Ecuador in 1999. The commission found “illegalities” and “irregularities” surrounding the issuance of the bonds due in 2012 and 2030, including issuance without proper authorization and exorbitant interest rates. Correa called the findings “disastrous” and “conclusive” and suggested that similar irregularities surround bond due in 2015, as well. In addition, the report suggested “irregularities” in bilateral debts with Brazil, Spain, and Italy. While the commission did not recommend specific actions the government should take, some members of the commission stated that those responsible for issuing the bonds should be put on criminal trial.

Ecuador’s Minister of Politics Ricardo Patiño headed the audit commission. Patiño had stated in August that Ecuador’s creditors could be forced to accept a governmental decision to cease payment on debt “even if some don't like it.” The day following the report’s release, Patiño told Bloomberg News that the Correa administration may seek restructuring talks with bondholders after completing its analysis of the debt's legality. Earlier during the announcement event , however, Patiño indicated that if creditors wanted to restructure the debt, those creditors would have to approach the government to talk, not the other way around.

During the announcement of the commission's findings in Ecaudor, applause and shouts of “We owe nothing, the debt is paid” and “Prison for the thieves” rang through the assembly hall. Investors, however, had little to cheer about. The prices of the bonds those investors hold have plummeted since August. Following the announcement, bond rating agency Standard & Poor’s downgraded Ecuadorian debt to CCC- from B-. President Correa stated that the final decision on whether to pay the debts will be announced the first week of December. For further discussion on President Correa's wariness of foreign debt, including IMF loans, see the prior blog titled "Ecuador Wary of IMF Lending".

Questions:
1) Assuming that the findings of the audit committee are correct, should Ecuador default on its debts? Can you think of any other ways to resolve the situation without resorting to default?
2) Should Ecuador invite a disinterested third party to evaluate the debt? Is the financial community likely to question the validity of the findings of the audit committee set up by the Ecuadorian government?