El Salvador | Forced pragmatism

admin | December 18, 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.

El Salvador has been a top performer for weeks and remains a top pick for its relatively low volatility and higher carry among the Latin America high yielders.  A lot of it has to do with forced pragmatism, a theme in El Salvador that should hopefully continue into next year after elections. The approaching negotiation with the International Monetary Fund is the best option and a potential positive catalyst for bond prices. Compared to other high yielders like Ecuador and Costa Rica, formal IMF negotiations are the practical first step. And El Salvador is prioritizing elections as a path to putting in place the policy management necessary for IMF negotiations.

There is low near-term event risk as negotiations with the International Monetary Fund have not yet commenced. The current credit watch is focused solely on budget management. Domestic auctions have been uneventful with full rollover of the low December domestic amortizations, and restricted access to external financing has forced lower spending and austerity. The auctions will require more scrutiny heading into next year as rollover rates go up. But El Salvador has some budget flexibility with a recovery in taxes and low structural spending. There is also the latent risk of new Eurobond issuance in the first quarter of next year if external risk remains favorable and authorities take advantage of an estimated $700 million of remaining authorized external debt issuance.

The investment narrative for an El Salvador overweight is prioritizing the highest returns with the lowest event risk.  El Salvador has not disappointed, muddling through on budgetary management and rollover of domestic debt.  The latest data through November show a complete recovery in taxes, including economic activity-sensitive VAT, while limited access to credit has slowed down spending considerably. Spending contracted year-over-year in October and presumably November and December. It follows the mantra for dollarized economies: if you cannot borrow, then you cannot spend. This forced budget pragmatism and mature economic recovery provides some breathing room, especially since the core fiscal deficit is closer to 3% of GDP instead of the counter-cyclical pandemic spending this year of a deficit reaching 10.5% of GDP. That started with initial counter-cyclical stimulus but recently required spending cutbacks through the last few months of the year.

El Salvador’s budget flexibility is temporary based on the larger short-term debt stock. That debt faces higher rollover risk into next year and seems to have limited access to a shallow local funding market.  Do not assume an accidental default over the next few months. The priority still is to repay or rollover the treasury bill market and buildup arrears to other liabilities, similar to Ecuador’s periodic episodes of cash flow stress.

There has been no debate or discussion or heterodox or progressive measures like a forced domestic debt restructuring. External debt service remains low at 0.23% of GDP in the fourth quarter of 2020 and 0.9% of GDP in the first quarter of 2021. There is also the latent option of re-tapping Eurobond markets if external risk remains favorable to countries at low risk of default if there is market access. The muddling through scenario over the next few months seems reasonable if priorities remain on debt liabilities and managing cash flow stress.

The event risk emerges after elections in the second quarter of 2021 on how El Salvador manages its 2021 funding program and high debt stock.  The $646 million backlog of multilateral loans pending approval in congress should provide an initial cushion as confirmed in recent announcements from Minister Zelaya. However, there is still an estimated $1 billion budget shortfall and a much higher stock of short-term debt.  There are a few options:

1. A base case scenario is formalizing negotiations for an IMF program after the end February elections with lower execution risk, stronger governability for the mature phase of economic recovery and high popularity ratings for President Bukele and control of the legislature. It is worth mentioning that El Salvador’s economic data is leading the pack for economic recovery in the region. The normal access program would only provide funds of $590 million in 2021 with potentially $500 million in Eurobond issuance funding the shortfall.  The question is whether the Bukele administration will try to tap the markets in the first quarter of 2021 ahead of formal IMF negotiations—similar to Ecuador in March 2019 prior to their IMF program. There is potential for around $700 million under domestic authorization (unfulfilled multilateral loans and unidentified external financing).  The markets may not be receptive without a formal IMF program and current yields at 9.5% would be viewed as desperate, similar to the 2052 issuance last July; however pre-emptive issuance is feasible as the 2052 have since recovered back to par.
2. The less ideal alternative is muddling through without an IMF program if the Bukele administration doesn’t want to commit to difficult austerity measures, specifically tax hikes. This would only be possible if the Bukele administration could source sufficient alternative liquidity through multilaterals or bilaterals.

The small gross financing needs of a smaller country logically provides more funding flexibility as small multilateral loans go a long way for a small $2.3 billion 2021 fiscal deficit.  The potential reference would be the Correa administration, when restricted access to capital markets in 2009 shifted all the financing to smaller multilaterals (CAF, FLAR) and bilateral loans (China).  This would represent a less ideal alternative but still a better alternative than outright default. The forced default would only be the last resort after having exhausted all other financing options. It is important to remember that small, open, dollarized economies benefit from policy pragmatism with heterodoxy a potential catalyst for disruptive capital flows and economic stress. The frequent informal discussions with the IMF suggest an awareness among the economic team on the potential menu of policy options. The best tradeoff for the Bukele administration is to at least try to negotiate an IMF program that would allow for gradual adjustment as opposed to the alternative of forced austerity on restricted access to credit or worse heterodox options that would catalyst economic crisis.

If Costa Rica serves as an example, then the next steps could initially focus on IMF negotiations as the preferrable alternative with the assessment then shifting to the commitment of the Bukele administration and the flexibility of the IMF.  This suggests higher optionality for positive than negative headlines while still offering interim high carry returns. The recent gains have been impressive but with still more room for normalization including bullish curve steepening with the curve still too flat compared to ‘B’ peers.