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El Salvador and Ecuador | Dollarization and pragmatism

| December 4, 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.

Countries pegged to the US dollar with shallow domestic funding markets have to keep a close eye on the risks of rolling over debt. The recent fiscal data show encouraging signs for El Salvador and Ecuador with a recovery in tax collection and more conservative spending. But dollarized countries cannot spend what they cannot borrow. This forces more conservative fiscal management and typically forces the pragmatic relations with the International Monetary Fund necessary to access external credit. Nuclear, more desperate options that would backfire into economic crisis usually do not work. Limited domestic funding forces an outward-oriented approach to financing gradual adjustment.

These two dollarized countries share similar challenges of sourcing sufficient funds through an election cycle.  The stakes are higher for Ecuador since too much fiscal austerity could backlash into a populist electoral outcome that would undermine policy management and threaten dollarization. The alternative leftist candidates in Ecuador do not seem to understand the constraints of dollarization. This explains the higher risk premium and recent underperformance of Ecuador relative to El Salvador.

The midterm legislative elections in themselves are less relevant for El Salvador’s Bukele Administration, which benefits from a 95% approval rating, the highest in the region. The rational economic team maintains regular dialogue with the IMF, which warrants high expectations for formal IMF negotiations after the elections.  The risk management near-term then focuses on the rollover risk of domestic debt.  These concerns perhaps are overstated. There is low rollover through the end of 2020 and more budget flexibility.  It would be highly unusual for a country to voluntarily default on markets that provide funding while smaller gross funding needs provides initial funding flexibility. The challenge then for El Salvador is the official commitment for an IMF program after the late February midterm elections.

El Salvador budget flexibility through year-end

The latest data show consistent recovery in tax collection from June through October with spending a function of whether the economic team can access exceptional funding.  The October spending shows a 6% year-over-year contraction due to limited access to funds and hence the 12-month rolling deficit stabilizing at 10.5% of GDP. The deterioration in the fiscal deficit this year is mostly explained by the 30% year-over-year increase in counter-cyclical spending as opposed to the 4% year-over-year decline in revenues.  This provides flexibility for lower spending for the remainder of the year and less urgency to tap extraordinary funds.

There is not as much urgency for stimulus. Consumer-related taxes and the Google mobility index point to continuing economic recovery, and the Bukele administration is still popular.  The domestic debt rollover also remains low through year-end with an estimated $67 million in maturities in December against the legal shelf of $311 million LETES issuance. There should be sufficient local market demand through year-end.  The rollover risks increase into the higher LETES maturities next year and hence higher pressure to formalize an IMF program after elections.  This would allow near $500 million in normal access in 2021 and potential $500 million access in Eurobond issuance to comfortably finance the 2021 budget, including rollover of delayed approval of multilateral loans.  The stakes are higher for next year with a rational approach to the IMF as the politically more palatable alternative than more desperate options under the constraints of dollarization such as forced austerity or heterodox funding that would backfire into economic stress. A rational economic team understands those constraints and supports an overweight recommendation in the credit.

Ecuador budget stress equals political risk

There has also been a recent recovery in tax collection in Ecuador, but the weak Moreno administration and higher stakes of the presidential elections reinforce the importance of sourcing sufficient funds.  The higher political risk requires less economic stress and emphasizes the importance of the next $2 billion IMF allocation this month.  It is not a question of near-term rollover risk for the liquidity relief from bondholders after the recent debt restructuring but rather a political commitment to fiscal discipline post-elections necessary to anchor medium-term debt solvency. The delays on funding could add to already high political risk.  The $500 million World Bank funds should soon provide relief; however, more important is whether the IMF board disburses the $2 billion on December 15.  This will depend on fast-track approval of the anti-corruption bill in the legislature before the December 15 recess.  There has already been progress in recent weeks, but a floor vote is necessary within the next few days.  The IMF fund disbursements alone are not a fix to what still looks to be a tight race and widening binary outcomes on centrist frontrunner Lasso against increasingly more populist rhetoric from the Correista candidate Arauz.  This justifies a more cautious neutral view and opportunistic positioning depending on poll results.

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