NEW YORK, July 23 (Reuters) - Ecuador's recent turn toward a more market friendly economic policies has lifted investor sentiment toward the Andean country, but follow-through beyond fiscal discipline will be key in order for the positive market reaction to continue, investors and analysts said.
Ecuador's stock market, with a near 10 percent gain https://tmsnrt.rs/2LhUCcd , has outperformed most of its larger South American neighbors so far in 2018. Its benchmark 2026 sovereign bond yield, recently above 11.5 percent, has fallen by more than 160 basis points over the last month to 9.8 percent.
Part of the upbeat market sentiment can be traced to May, when social democrat President Lenin Moreno named an economy minister from within the business community.
Richard Martinez arrived with a plan to reduce external debt and the fiscal deficit. He has reached out to multilateral financing organizations and has driven negotiations over legislation that would allow 8-to-12 years of income tax exemption for new private investment over the next two years.
"This incentive would allow to accelerate both local and foreign private investment and foster growth," said the Ecuadorian economy and finance ministry in an emailed reply to Reuters.
With Ecuador's currency pegged to the U.S. dollar, the country has effectively sacrificed an independent monetary policy, putting an even sharper focus on fiscal policy.
The fiscal consolidation plan has pleased investors according to Giulia Pellegrini, deputy head of emerging markets economic research for BlackRock in London.
Preliminary data for the first six months of 2018 show a "significant fiscal tightening," both from a reduction in new spending and from lower costs in recurring spending, she said.
"The government has shown that it means business in the first half of the year," Pellegrini said. "We have good signs but we really want to see them complete this process."
A reform of the mining code would also be important, analysts said, if the government expects the private sector investment to fill the void left by the government's belt tightening.
"Its a two-fold issue. Its not only trying to correct the fiscal imbalance that they have but also trying to incentivize investment so that the economy becomes less reliant on government spending for growth, which had been the case over the past decade," said Renzo Merino, an analyst of sovereign risk at Moodys Investors Service in New York.
Ecuador's U.S. dollar-denominated sovereign bond yield spread stands at 637 basis points over benchmark U.S. Treasuries, as measured by the JPMorgan Emerging Markets Bond Index Global. That is down from a 1-1/2 year high of 806 basis points hit a month ago, but still roughly 300 basis points wider than the benchmark index.
"When markets realize that Ecuador is reducing fiscal expenditure and that the macroeconomic environment is better than 2017, we anticipate that the pricing of Ecuadorian bonds will recover," the economy ministry said.
"When conditions guarantee a sizable amount (of debt issuance) at single digits (yield), Ecuador would consider tapping the world markets."
CHALLENGES AND GREEN SHOOTS
Ecuador pays a confidence premium after recent defaults on its debt. Traders in credit default swaps are pricing in a probability that Ecuador will default in the next year at 6.4 percent, compared to between 1.0 percent and 1.4 percent for Colombia, Mexico and Brazil. Argentina's probability stands just above 3.0 percent while Venezuela, with a crumbling economy, is near 73 percent.
"I don't think an Ecuadorian default is a realistic discussion right now. They are cutting back spending and they have piecemeal sources of financing," said Siobhan Morden, head of Latin America fixed income strategy at Nomura Securities International in New York.
"But there's a distrust given their track record of defaults," she said. "When a country is running a huge deficit and has no access to external capital markets, investors start to debate how it is going to pay."
The OPEC member is particularly vulnerable to globally tightening financial conditions as its shallow market makes it heavily dependent on external financing, according to Richard Francis, a director at ratings agency Fitch.
"Ecuador is still adjusting to external shocks that have exposed underlying structural imbalances in the country's economy," wrote International Monetary Fund staffers after a recent visit.
The shocks have been felt across emerging market economies as the U.S. dollar strengthened in recent months and, combined with rising interest rates, served to drive financing costs higher.
But the IMF also highlighted increased transparency as well as steps to "strengthen fiscal institutions and re-establish a competitive private-sector driven economy."
The government said it is in "very close and active dialog" with the IMF, the World Bank and other multilateral financing institutions, "mainly in the context of technical assistance missions."
(Reporting by Rodrigo Campos; additional reporting by Alexandra Valencia in Quito; Editing by Daniel Bases)