El Salvador | Bukele game plan

Siobhan Morden | May 21, 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.

While El Salvador’s Economy Minister discusses a program with the International Monetary Fund, the congress approves a cooperation agreement with China. There seems to be no coordination. The bottom line is that the political agenda in El Salvador is incompatible with an economic agenda that relies on external credit to finance the budget. China is not a lender of last resort and is not a substitute for the IMF. The rising diplomatic tension between the US and El Salvador increases both the Bukele risk premium and the IMF risk premium and argues for reducing exposure to El Salvador.  There is an unstable equilibrium between the political and economic agendas that implies higher policy risk and higher volatility.

The headline risk continues with the publicly visible diplomatic tension between El Salvador and the US. El Salvador is trying to formalize an IMF program with necessary support from the US as the largest stakeholder. The access to external credit is critical. Domestic funding markets are saturated, and dollarization limits deficit financing. There are contradictions within the political agenda for the Bukele administration. The pursuit of autocratic control may undermine another equally important part of the political agenda: accessing external credit. El Salvador cannot spend if it cannot borrow, and the Bukele administration cannot govern without a funded budget.  The access to external credit typically requires strong democratic institutions.

It almost seems that President Bukele is learning on the job and has not yet reconciled these conflicting objectives. There does not seem to be much if any coordination between Economy Minister Zelaya discussing IMF program specifics like e-commerce taxes and President Bukele tweeting about unconditional China loans, which the markets view as a veiled substitute away from US-sponsored multilateral lending. The diplomatic tension also continues with headlines of a leaked US State Department list of corrupt El Salvadorean officials and consistent criticism from US politicians. There does not yet seem any clear path toward a diplomatic compromise, with the US support a pre-requisite for DC-based multilateral lending.

There are two possible paths: either the US coordinates diplomatic relations directly with El Salvador or indirectly through the IMF as an enforcement mechanism.  If there is no immediate announcement of an already delayed IMF staff level agreement, then this suggests no reconciliation yet on diplomatic relations. The recent noisy headlines are a reminder of the unresolved diplomatic tensions. There is also no clarity on the IMF programs, with the latest delays contradicting comments from the El Salvadorean economic team about a fast-track agreement. The IMF program remains the base case scenario; however, the risks are for protracted delays until there is some workable diplomatic compromise.  Perhaps it depends on the budget stress, with the analysis quickly shifting to the 2021 financing program and alternative sources of financing.  The newly inaugurated legislature has been quickly approving multilateral loans with $830 million the second week of May and $600 million the third week. Neither the timing nor the terms of these funds are clear, with perhaps $600 million accessible for budget support on the carry-over of previously committed funds from last year and then an estimated $1.1 billion shortfall depending on how quickly other funds are approved, or, more important whether these funds are conditional for an IMF program. The diplomatic tensions have already spilled over to financial markets with higher cost of funding and assumably restricted access to Eurobond markets.  The risk of further financial market contagion should eventually prompt a more conciliatory stance, especially after exhausting the pipeline of recently approved multilateral funds.

If we attempt to back out the market probability of an IMF program based on current 8% levels on the ELSAL’50, then it is probably 80%-to-20% on a weighted probability of downside (10% yields) versus upside (7.5% yields). The IMF program remains the base case scenario; however, the risks are for extensive delays until a diplomatic compromise that is either intrinsic (via governance criteria) or extrinsic to the IMF program (via bilateral relations).  The risk for bondholders is that markets unwind the IMF optionality on the uncertainty of delays or the persistence of negative headlines.  The technicals are also unfavorable for the core long positions unprepared for this new phase of higher political risk.  This reaffirms a more cautious view and prior recommendation to downsizing overweight exposure or rotate into Ecuador until there is a more favorable balance of risk and reward or higher conviction for an IMF program under perhaps the catalyst of financial market or budget stress.