El Salvador | Bitcoin backlash

Siobhan Morden | June 11, 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. This material does not constitute research.

El Salvador this week became the first country to approve Bitcoin as legal tender. The market initially brushed off headlines about the idea as noise, but President Bukele submitted the Bitcoin proposal and the legislature quickly approved. Now the market is wrestling with the reality of more difficult negotiations with the International Monetary Fund. The economic team has been negotiating an IMF program for over a year with recent announcements reaffirming its importance. But the latest developments all show a tendency for flashy and unexpected announcements from the president that seem to contradict or at least question the plan from his economic team. There was no due diligence by El Salvador on the implications for the IMF program. The chances of a program now may be at 50-50, it might have to get worse to motivate coordination for a rational economic program.

There is not the same parallel to Brazil, which has the anchor of a well-known technocrat like Minister of the Economy Guedes to provide a buffer to any radical initiatives and to exercise full autonomy to pursue economic policy management. The Bitcoin announcement again reinforces the importance of the IMF program to serve as an anchor with a clear economic framework, technical expertise and rational policy management that mitigates against irrational headlines. The plans for Bitcoin under an increasingly autocratic regime will likely only compound concerns about corruption, money laundering and the independence of regulatory agencies. If the Marshall Islands serves as a precedent, there was huge pushback from the US and IMF.

The bottom line is that El Salvador faces an underfunded budget that depends on access to external credit with the IMF as the gatekeeper. The market punishment might have to continue before reinforcing a more rational coordination between the political and economic agendas.  A 50-50 probability targets maybe another two points lower on the ELSALV’41, with further downside from further delays over the next few months.

The latest comments from IMF spokesperson Gerry Rice confirm a more difficult phase of negotiations: “Adoption of Bitcoin as legal tender raises a number of macroeconomic, financial and legal issues that require very careful analysis.” The IMF simply stated the obvious. There are risks to Bitcoin that demand reassessment of the economic program. The best case is delays while the worst case is a suspension of talks.  The status on negotiations shifted from nearly finished in late April to modifying for good governance criteria in May to now potentially an overhaul on both fronts under the latest Bitcoin announcement.

This is not a fast-track process on the inaugural launch of a dual currency. It has broad macro implications, and El Salvador seems without any prior due diligence on the necessary legal and economic implications. The status of negotiations is increasingly more complicated and requires understanding not only IMF relations but also the implications for diplomatic relations with the US Treasury and State Department. The IMF seems flexible with ongoing discussions; however, it is not clear whether there is similar flexibility with the US, which is the largest shareholder on the IMF board.

The dependence upon external capital is critical for dollarized economies not only for budget management but for broader liquidity management of consumption and investment.  This requires a US-friendly strategy and formalization of an IMF program that would allow broader access to capital markets and DC-based multilaterals. China is not a lender of last resort and not a substitute for multilateral loans of $1.5 billion to $2.0 billion a year. The focus next shifts to the financing and rollover risks, with El Salvador facing large gross financing needs of $3.2 billion this year and an estimated shortfall of $1.58 billion, assuming timely disbursement of the estimated $850 million of CABEI loans this year and uncertain disbursement of other multilateral loans.

The inability to finance deficits under dollarization and the saturation of domestic funding markets increases the dependence on the IMF to avoid rollover and funding stress. The disbursement of CABEI loans and the IMF SDR allocation will become increasingly important for reducing budget and rollover stress in the next few months. This month alone it could become complicated with $174 million of CETES maturing and total rollovers of $302 million, with the next bulky $646 million CETES maturing in September.  There have yet been no signs of rollover risk; however, it will be critical to again start monitoring treasury auctions for the funding rate and the bid-to-cover ratio and sufficient appetite for issuance.  Budgetary management could become increasingly complicated later this year, and that will become a test on how flexible the Bukele administration is. Policy pragmatism looks essential for accessing external credit.

The market probability of an IMF program has changed. The likelihood is quickly unwinding from previous 75% to now maybe 55% based on current levels on the ELSAL’41, on a weighted probability of downside (10% yields) versus upside (7.25% yields) risks. The extensive delays may continue to lower the probability, with an increasingly undefined path towards a diplomatic and economic compromise. The technicals are also unfavorable for the core long positions unprepared for this new phase of higher political risk and potentially higher rollover and financing risks.  This reaffirms a more cautious view and strengthens the case for downsizing exposure. Investors should shift to an underweight until there is more favorable balance of risk and reward. That balance could arrive at higher yields or higher conviction for an IMF program under perhaps the catalyst of financial market or budgetary stress that reinforces policy pragmatism from the Bukele administration.