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Latin America | Debt solvency in transition

| October 16, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The aftershocks of pandemic have left the ‘B’ credits across Latin America still struggling with solvency. The International Monetary Fund and other multilaterals have provided significant support to countries like Costa Rica and El Salvador while bondholders have also provided cash flow relief for credits like Argentina and Ecuador. But there is an overhang of future cash flow burden and solvency risk if these countries do not quickly resume trend GDP growth and unwind fiscal stimulus. The crux of the problem is the risk of a protracted economic recovery and the social and political stress of any pre-emptive fiscal discipline or austerity. Avoiding future debt restructuring will depend upon how quickly these countries get back on track, the commitment to fiscal discipline and the access to liquidity in the meantime.

The likelihood of future restructuring should depend on the extent of the economic downturn and phase of economic recovery. The dollarized countries like El Salvador and Ecuador are most at risk for a sudden stop under the rigidity of dollarization. However, the stimulus of counter-cyclical spending after getting multilateral funds should encourage a faster recovery.  The latest tax collection data for both countries show a rebound, while the faster re-opening in Ecuador and El Salvador may also provide a quicker normalization. The Google mobility reports show Ecuador and El Salvador at the least deviation from the pre Covid-19 baseline compared to Argentina and Costa Rica.   The recent economic activity data in Costa Rica show a worrisome flattening trend while confidence indicators in Argentina for September reflect the current balance of payment stress.

The next phase of recovery should focus on how quickly counter-cyclical stimulus shifts to pro-cyclical adjustment. The 2021 budgets should provide a preview for commitment. Its notable that Costa Rica, El Salvador and Argentina still show above-trend fiscal deficits for next year that exceed the IMF Rapid Financing Instrument staff report recommendations. Argentina and El Salvador are still at the widest deviation from their near primary balance in 2019.  Ecuador is the potential exception with the IMF proposed primary deficit shifting from 5.8% of GDP in 2020 to 1.4% of GDP in 2021.  These ambitious targets will depend on future commitment from the next administration after elections as pressure increases for counties like El Salvador and Costa Rica to quickly reaffirm their commitment to fiscal discipline.

The commitment will likely hinge on the formalization of an IMF program that provides a framework for debt sustainability as well as a liquidity cushion through the transition.  Ecuador is the first in line to formalize an IMF program.  Costa Rica is in limbo, and El Salvador is likely waiting until after the elections next year.  It is not a surprise that the highest yielding Argentina would have the weakest IMF program without much if any conditionalities—or reassurance for debt sustainability—and without much if any access to new funds.  Those countries at risk are those with the highest gross financing needs with Argentina and Costa Rica clearly in this category and those that are reluctant to embrace a coherent adjustment program.

It then shifts to execution risks as austerity measures contend with potential social and political pressures.  Costa Rica is again in this category for the current policy paralysis that pushes back against the initial proposal for adjustment. El Salvador trades with a Bukele risk premium on the uncertainty of commitment after elections to a formal IMF program. However, governability could be stronger after elections with majority control of the legislature and the forced pragmatism of dollarization. Ecuador also benefits from a stronger executive branch and dependence on external capital under dollarization. Ecuador also trades with a similarly high risk premium, awaiting confirmation of policy continuity amidst a large proposed fiscal adjustment of 5% of GDP through 2025 against base year 2019.

This is the biggest challenge to managing the social and political pressures. Fiscal adjustment could potentially be much more aggressive.  Costa Rica has perhaps the worst starting point for the highest structural deficit in 2019, with the initial IMF guidance from the RFI staff notes earlier this year biased for upward revision.  Argentina is the weakest of these credits with insistence on a public consumption growth model and perhaps insufficient debt relief if policy mismanagement continues to undermine foreign exchange reserve accumulation.

The balance of these risks are critical determinants of relative performance. There is insufficient risk premium for Costa Rica and positive optionality for the higher yielding countries like El Salvador and Ecuador if there is commitment to IMF programs after elections.

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