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El Salvador | Lessons learned

| March 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.

The extensive negotiations between El Salvador and the International Monetary Fund suggest a fast track to a final agreement in May and perhaps even lower execution risk. The markets have already largely priced in the positives of an IMF program, but there should be residual upside from staff approval following an IMF mission as early as next month. One important gain for El Salvador is the potential for Eurobond issuance to help an under-funded budget this year. But any new issue premium should be minimal if the IMF has provided a financial anchor and if high yield EM offers few alternatives.

There have not been any headlines since the initial confirmation from Minister of Finance Zelaya of formal IMF advanced negotiations.  This is not the same open public forum as the IMF negotiations in Costa Rica but rather informal and behind-closed-door discussions that have occurred since the last Eurobond issuance in July 2020. The negotiations should be well advanced if only for the lengthy period of informal discussions.  The April 2020 IMF staff notes from the Rapid Financing Instrument should provide a preview. There was specific IMF recommendations for a cumulative fiscal adjustment of 3% of GDP from 2021 to 2024, including revenue-enhancing measures and a decrease in current spending to hit a primary surplus of 3.5% of GDP by end 2024.  It is clear that after El Salvador’s debt rose to nearly 90% of GDP last year to finance a 30% year-over-year surge in spending, hitting IMF targets will require not only an unwind of Covid-related spending but further cutbacks and revenue measures.

There has already been a reduction in spending through the fourth quarter of 2020 with limited access to credit, forcing a cutback on spending closer to the structural nominal deficit of 4.3% of GDP (annualized basis on 4Q20) compared to the 10% of GDP performance for full year 2020. The revenue-enhancing measures are typically the more controversial component of any adjustment program; Costa Rica heard loud opposition to tax hikes. Minister Zelaya suggests that there are no plans for tax hikes but rather a reduction in tax evasion and other politically palatable administrative measures. This may create some friction with the IMF.  The spending cutbacks will probably focus on capex with the IMF recommending a reduction in the wage bill and centralizing procurement across ministries and public sector agencies. The lesson learned from Costa Rica is that the IMF has been flexible on accepting a reasonable economic program that the country proposes under a “normal access” lending facility.  It is not clear why it would be different for El Salvador.

The debt ratios in El Salvador are higher at 90% of GDP with higher rollover risk in saturated domestic funding markets, but the nominal structural fiscal deficit of 4% of GDP is lower compared to 7% of GDP Costa Rica.  The Costa Rica program includes a lengthy phase-in period, bi-annual reviews and gradual adjustment that reverts a 2.6% primary deficit in base year 2019 to a 2.8% of GDP surplus in 2026. The current high debt ratios at 72% of GDP show no improvement through 2026 for the slower pace of adjustment and consistent debt accumulation to finance the high nominal fiscal deficit. It is not clear whether the higher debt ratios in El Salvador will force a revision of the previously discussed 3% of GDP adjustment in 2024.

The one clear difference for El Salvador is that the financing program will depend disproportionately on external funds. The 2021 funding program has an estimated shortfall of around $700 million even after an estimated $450 million IMF disbursement. The saturation in local funding markets suggests either a multilateral loan package that could broaden official lending beyond the IMF, or alternatively renewed access to Eurobond markets.  There had already been recurrent whispers earlier this year on potential Eurobond issuance.  The context would now be different with stronger investor demand under the anchor of an IMF program and few other attractive high yield alternatives that partly immunize against UST risk.  El Salvador at current yields offers the highest carry for an EM credit with an IMF program.  Meanwhile, the supply risk should be manageable for a smaller country with smaller gross financing needs (around $2 billion a year).   This suggests a tight new issuance premium that perhaps targets the less crowded intermediate sector of the curve and maybe explains the much wider 165 bp z-spread differential ELSAV’32-COSTAR’31 against the 64 bp differential of the ELSALV’23-COSTAR’23.

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