Ecuador: Is it nuts to invest here?

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.

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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 fiance 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 suspectwas 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 thatCorrea 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 Pstor, 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 andnine 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.