El Salvador | Quantifying the IMF program

Siobhan Morden | February 19, 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.

Event risk during negotiations with the International Monetary Fund is a dominant theme for stressed and distressed credits at this mature phase of the pandemic crisis. El Salvador is next in line to approach the IMF with only a few weeks until midterm elections. Informal IMF negotiations will have to become formal after the country’s elections to reduce the cost of financing and open external markets for Eurobond issuance. El Salvador has cut back spending since October 2020, with cash flow management critical after five months of likely fiscal austerity. Approval of multilateral loans could get delayed after the legislative turnover on May 1. The confirmation of formal IMF talks should push bond prices higher, but do not look for full convergence with Costa Rica since El Salvador’s higher liquidity risks increases the binary policy risks of success or failure of an IMF program.

The markets re-priced earlier this year on the possibility of an IMF program. Amherst Pierpont still has a high-conviction expectation of an imminent IMF announcement after elections. This seems the most rational policy option to relieve months of budgetary stress with financing always more politically palatable than spending cutbacks. The months of informal dialogue with the IMF should have allowed for in-depth discussion about the policy options under dollarization. It would seem reasonable to at least explore the prospects for an IMF program that would allow for near-term access to Eurobond markets and relieve budgetary stress. The November monthly economic activity data suggests that the economic recovery is losing momentum with a clear political preference for a more gradual fiscal adjustment that does not threaten the recovery.

The budgetary stress has been accumulating since October with scarce funding options forcing cutbacks in spending. Near-term domestic debt rollover should be uneventful with frequent successful auctions and a clear prioritization on Letes payments, with $78 million in November issuance against $130 million of maturities. However, the aggressive Letes net issuance of $418 million in 2020 has reached legal saturation. This shifts the funding program externally for a potential mix of Eurobond debt issuance and multilateral loans. The $1.885 billion fiscal deficit this year is short around $1 billion—assuming full release of pent-up $646 million multilateral loans with legislative approval after the turnover for majority control on May 1. There is residual authorization for $1.35 billion for external borrowing, of which $646 million comes from multilateral commitments with the remainder $670 million in possible Eurobond issuance. It would be difficult to source external issuance without open commitment for an IMF program. The worse liquidity and solvency ratios post-Covid would require commitment to fiscal adjustment as a pre-requisite to borrow abroad. This would allow the IMF to bridge the remaining funding gap (435% IMF quota of $1.8 billion or $600 million of annual disbursements under normal access).

Eurobond access seems plausible if the markets believe that the Bukele administration in earnest seeks to negotiate an IMF program. There is still deal risk on IMF negotiations. The deal risk of IMF negotiations is highly concentrated on the commitment of President Bukele to stronger governability and hence lower execution risk—unique compared to other countries with IMF programs. President Bukele benefits from unprecedented high 95% approval ratings midterm and will probably easily sweep congressional control, but tax hikes are always controversial. It’s not necessarily about unwinding fiscal stimulus. It is also about either further cutting spending or increasing revenues to tackle a now larger debt stock from counter-cyclical Covid-related spending.

There is debate about where El Salvador should trade relative to peers. Costa Rica and El Salvador are a common relative value pair. Costa Rica now trades at normalized pre-Covid yields with markets discounting high IMF optimism after six months of domestic dialogue and broad societal and political consultations. El Salvador has recently repriced for IMF optimism: however, there is still significant 100 bp to 275 bp of relative spread premium with a distressed flat curve and 9% long-end yields. El Salvador should probably continue to offer higher credit risk premium relative to Costa Rica for the higher liquidity risks and higher debt ratios. There is budgetary flexibility for the much smaller structural fiscal deficit as well as the much smaller gross financing needs of a smaller country. However, the higher rollover and liquidity risks amplify the IMF relations between success and failure with policy inflexibility under dollarization. This would logically require extra credit risk premium until investors are comfortable on the Bukele commitment to an IMF program. Look for still another bounce on headline IMF announcements with ELSALV’52 perhaps rallying closer to normalized yields of 8.5% and a stronger rally on the shorter tenors with bullish curve steepening. The already strong gains perhaps argue for some profit taking; however, the still near-distressed yields argue for still a small overweight on what appear as attractive risk/reward on relative terms with El Salvador in its own high yield category compared to ‘B-/CCC’ credits.