Latin America | IMF event risk

| February 5, 2021

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.

Yields on Latin American sovereign debt have renormalized toward pre-Covid levels despite a trend of credit rating downgrades. This begs the question of whether current valuations compensate for the risks.  ‘B’ credits such as El Salvador and Costa Rica have outperformed in light of potential IMF programs while distressed credits such as Argentina and Ecuador have lagged but remain equally dependent upon IMF relations.  This remains the dominant theme across most high yielders with total returns now increasingly dependent on country-specific event risk including either the negotiation or execution of IMF programs.

There are still a few high yielding sovereigns like the Bahamas and El Salvador that have not yet quite converged to pre-Covid levels.  However, the impressive gains for ‘B’ credits such as El Salvador and Costa Rica in January suggest higher sensitivity to any disappointment.  The IMF now serves a critical role across the region for the weaker credits. The IMF involvement raises expectations of access to near-term liquidity and reversal of what has been a broad-based deterioration in creditworthiness across the region. Ecuador was the first to negotiate a formal program post-Covid. Panama and Costa Rica soon followed. El Salvador looks likely to commence negotiations after elections next month. IMF relations in Argentina look unresolved. There’s risk of renegotiation in Ecuador.

This now requires a more rigorous assessment of execution risks for Costa Rica and negotiation risks for El Salvador, Argentina and Ecuador. The stakes are high for all these countries as the IMF represents the lender of last resort and provides necessary credibility to keep access to capital markets.  The market cannot underestimate the execution risk of unpopular fiscal austerity, slow or stagnant economic recovery, and ideological constraints in Argentina and perhaps Ecuador depending on election results.

ECUADOR | IMF POST ELECTIONS. It is all or nothing depending on policy management after elections.  None of the presidential candidates has accepted the IMF program as is. This is understandable since the IMF program is typically negotiated through any political transition. The IMF negotiations will not be easy for any candidate. Social and political pushback to austerity has increased through the election cycle. All the candidates have rejected the proposed 3% VAT hike. It will be difficult to find a substitute for the rigidity of budgetary spending with public payroll cutbacks facing social and political constraints.  The Moreno administration easily agreed to initial requirements for economic reform through 2021; however, Ecuador cannot commit the next administration to follow through with tax hikes in 2022.

Ecuador was unique as the first Latin American country to formalize an IMF program after Covid with the subsequent program in Costa Rica much less austere. There is a notable difference between a gradual target 4% of GDP primary surplus in Ecuador against only a 1% of GDP primary surplus in Costa Rica. There is a clear difference between the exceptional versus normal loan access and the track record for debt repayment. However, it is difficult to reconcile the comparative DSA for a higher structural fiscal deficit and higher debt ratios in Costa Rica.  This would argue perhaps for some renegotiation of softer or more gradual adjustments, but that should still depend on the ideology and pragmatism of the next administration. There is also the possibility of a revised IMF program under a Lasso administration. However, it becomes increasingly more difficult for an Arauz or Perez administration.  The bottom line is that the IMF has leverage as the only obvious recourse to credit while dollarization prevents deficit monetization and each country faces saturation in domestic markets. There is no reconciliation between populism and weak dollarization and scarce alternatives between high-risk heterodoxy and the policy pragmatism of a negotiated IMF program. This tradeoff determines binary event risk for bondholders with high uncertainty into this weekend’s elections and validates our neutral recommendation.

ARGENTINA | IMF POLITICAL COMPROMISE.  The IMF negotiations represent a political compromise to extend the repayment of $43 billion in loans from the Macri administration for a country that is bankrupt and unable to pay the front-loaded amortization schedule.  The IMF program may be mostly symbolic; however, normalization of relations requires a coherent economic program critical to stabilize sentiment and reverse the balance of payment deficit. This is the crux of the problem with a clear ideological departure between Kirchnerismo and the IMF on what represents a coherent economic program.    The approaching midterm elections and the weak economic recovery further aggravate the negotiations over the high 4.5% of GDP primary fiscal deficit.  For comparative reference, this would represent a much higher fiscal deficit for the other countries negotiating IMF programs.  The fiscal anchor is a minimal requirement to reverse towards an eventual stable equilibrium and gradual accumulation of FX reserves necessary for debt repayment.  It is a higher risk strategy to postpone IMF negotiations until after October midterm elections and a potential binary impact on credit risk.  The Kirchnerismo influence ahead of October midterm elections poses a serious ideological threat that may complicate IMF negotiations.  The soft March deadline seems to be slipping into May according to the latest official rhetoric from Minister Guzman that may again slip into after October midterm elections. The IMF program is not a solution in itself with a weak Kirchnerista economic framework that suggests an uncertain and gradual path towards debt sustainability and hence warrants a conservative underweight/neutral recommendation.

COSTA RICA | IMF EXECUTION RISK. The staff level agreement should soon formalize into board approval next month.  There has been a significant run-up in bond prices through the later stage of negotiations culminating in the staff agreement and normalization in yields with the entire curve trading at par and pre-Covid levels. It is important to remember that the execution risk is high with yet no domestic consensus for the weak economic recovery, pre-election cycle and the cultural rejection of higher taxes.  The IMF program will set the calendar with expectations of May-June deadline for critical reforms such as the public wage legislation.  This will represent a litmus test for the success/failure of the IMF program and whether yields grind lower or retrace back to distressed levels near 10%.  We would interpret as asymmetric risks with an IMF-light program that only achieves a 1% of GDP primary balance in 2023 with high 5% of GDP debt service and debt ratios only reverting back to pre-Covid levels of 50% of GDP in 2035.  The convergence towards BB credits like DomRep at much lower 5.5% yields for longer maturity bonds would require full execution of the IMF program on only a gradual path through 2024-2025. It’s a tradeoff between orderly or disorderly approval process or a shift to higher risk strategy that would include domestic debt restructuring.  Our base case scenario assumes progress on the IMF program; however our conviction is probably lower than what’s implied on current yields with potential for higher volatility as political resolve is tested in coming months. We reaffirm our recommendation for neutral exposure for asymmetric execution risks after recent outperformance.

EL SALVADOR | NEXT IN LINE FOR IMF PROGRAM. The impressive gains this past month was the reality check that a formal IMF program is the most practical option with declining political stigma after formalizing programs in Panama and Costa Rica. The practical reality is that the Bukele administration is short on their 2021 funding program and faces restricted capacity to raise domestic funding. The IMF program is the necessary pre-requisite to access external capital and a better alternative than the heterodox options under dollarization.  The IMF assessment is different for El Salvador.  The stakes are higher on success/failure for the limited domestic financing capacity and higher rollover risk.  It’s also less about execution risk but rather the commitment of the Bukele administration.  The actual adjustment may be easier for the lower structural fiscal deficit.  There are also fewer social and political risks for a popular Bukele administration with stronger governability post elections and faster economic recovery from pro-cyclical fiscal stimulus. It all comes down to the commitment of the Bukele administration with clarity soon following elections next month. There is probably still some residual upside on the headline confirmation with a distressed flatter curve and misalignment to other B credits with IMF programs while still trading at a premium to pre Covid levels. The recent outperformance perhaps warrants a reduction to just a slight overweight recommendation.

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