The International Monetary Fund is exercising tough love with Ecuador, but investors worry that the agency's new backbone might undermine its own credibility and push Latin America back toward a debt crisis.

In permitting Ecuador to become the first country to restructure payment on its Brady bonds, the debt that emerging economies took on to repay defaulted loans, the IMF has imposed a drastic tax restructuring. It is negotiating debt relief from private creditors and other reforms as a condition of a bailout package.

An Ecuadorian default could make investors even more skittish about investing in Latin America -- which has already seen crises in Brazil and Venezuela -- particularly if other countries follow Ecuador's example and move to restructure their debt. Already, holders of Ecuadorian bonds will be receiving principal payments below the Brady face value, if they receive payments at all.

While the IMF's ambition of forcing private investors to share the pain of macroeconomic instability is admirable, the overall effect could be to plunge Latin America and other emerging markets back into the kind of economic turmoil the Brady bonds were intended to ameliorate.

The IMF is "jeopardizing an entire asset class of the market," says Scott MacDonald, economist at KWR International, an independent consulting firm. "IMF funding was never a guarantee, but there was an understanding that this was supposed to be a sacrosanct instrument."

Already the IMF's move has had repercussions on the market. Moody's recently downgraded the already junk-rated Ecuadorian Brady bonds to technical default, or Caa1, from B3 after the announcement that the country would postpone interest payments.

"The IMF has been supporting and encouraging the Ecuadorian government for a restructuring of its Brady bonds, which will be quite complex," says Francesc Balcells-Forrellad, associate analyst at the sovereign risk unit at Moody's. "An unsatisfactory solution for investors risks putting Ecuador out of the markets for years to come."

Ecuador's government, however, is trapped by political struggles between the executive and legislative branches. That's prompted Latin American Pollyannas such as J.P. Morgan, which is heavily invested in the region, to acknowledge that the possibility of month-end congressional approval of stated reforms is remote.

Without the stipulated reforms, Ecuador's economy will presumably free fall into deeper chaos, marked by negative growth rates and no IMF safety net. And while Ecuador itself might not pose a contagion risk because of its relative size, the IMF's behavior might.

While allowing Ecuador to fall, the IMF could prop up Argentina's weakened economy by expanding existing credits or by implementing the Contingency Credit Line, which IMF Managing Director Michel Camdessus dreamed would never have to be activated.

The Contingency Credit Line was designed as an insurance package for countries with good policies to build investor confidence and avoid a regional contagion. Argentina's economy, suffering from stagnant reform and continuing contraction, could hardly be described as a model of good policy, but it is large enough to affect neighboring countries and thus worthy of the IMF's double standard.

"Ecuador is small enough to fail -- $6 billion in debt the country is not that huge in the great scheme of things," says Walter Molano, chief Latin America economist at BCP Securities. "The IMF can afford to take some very expensive lessons with Ecuador."

It appears the IMF has two distinct sets of rules: one set for small countries that can demonstrate the integrity of IMF demands and another for larger countries that all but guarantees continued support despite slow reformations.

Larger countries like Nigeria that are regionally important and have been diligently making their debt payments may see this inconsistency as an opportunity to slack on their debt obligations or to depend on desperate bailouts by the international community rather than implementing real, lasting reforms that attract long-term foreign investments.

To simultaneously calm foreign investors and effect real reform in shaky economies, the IMF may want to practice a more realistic and uniform version of its tough-love program.

The first step would be to give Ecuador a reasonable timetable for reforms, while emphasizing the unique and one-time nature of the current debt restructuring. The second would be to expect larger countries to also follow through on reform obligations, thus giving universal weight to IMF threats. Without such universal realism, investors will be left questioning the value of IMF backing.

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