The Big Idea
El Salvador | Higher financing risks
Siobhan Morden | July 16, 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.
El Salvador’s Bukele administration may soon reach a crossroads. Some investors had expected financing constraints would force policy pragmatism from the administration and negotiations with the International Monetary Fund would renew in earnest. But the prospects for an IMF program are now probably close to zero. There has been no progress on tackling the weak fiscal finances necessary for an IMF program and no apparent progress on improving US diplomatic relations, which hinge on a credible approach to corruption, improving transparency and strengthen anti-money laundering regulations. The Central American Bank for Economic Integration is providing support, and the country should have sufficient near-term financing through either voluntary or forced local financing. But there is no coherent medium-term financing or solvency plan without an IMF program. The unofficial debate amongst local participants is now shifting towards worst case scenarios including the possible nationalization of the pension funds. This reaffirms our high conviction underweight and target for distressed yields above 10%.
Exhibit 1: El Salvador’s source of funds
The consistent underperformance of El Salvador’s Eurobonds shows increasing uncertainty about IMF relations. The market should not underestimate the importance of an IMF program as the gatekeeper to access external credit—either through Washington, DC-based multilaterals or Eurobonds—as well as the anchor for medium-term debt sustainability. The budget now faces an important shortfall with domestic markets saturated and access to external markets restricted. The recently approved $600 million CABEI loan should cover the $646 million September CETES amortization, and the $400 million IMF SDR loan disbursement in August will also provide some budget relief. However, that still leaves an important shortfall, assuming there is regulatory flexibility to shift IMF SDR to budget support. This financing gap also excludes the recent spending commitment for the BTC subsidies ($120 million) and the minimum wage hikes (around $300 million) with still upside risks for BTC public infrastructure.
The obvious alternatives are arrears financing or forced spending cutbacks (around $300 million) and the drawdown of the treasury bank deposits at the central bank ($250 million). There has already been a noticeable cutback in capex spending this year with forced pragmatism probably shifting the full year budget closer to $1.54 billion from $1.885 billion. It is important to remember that you cannot spend what you cannot borrow, so restricted borrowing forces pragmatism to lower the fiscal deficit. The reallocation of the CABEI loans for the maturing CETES will also finance these bulky amortizations and leave much lower rollover and financing risks for the remainder of the year, assuming successful LETES auctions.
The financing stress shifts back to the budget in the fourth quarter of this year after having exhausted the IMF, CABEI loans and residual stock of central bank cash deposits. The next list of alternatives are increasingly heterodox options. Those include revising regulations to voluntarily expand capacity for local funding or quickly shifting to coercive alternatives such as forced local funding if investor sentiment deteriorates. The legislative majority could easily revise regulations that allows for a higher issuance cap for LETES (25% of current revenues) concurrent with a reduction in liquidity requirements. If unable to increase sufficient demand, then typically the strategy shifts to more coercive alternatives. This explains the latest local press headlines about the forced nationalization of the pension funds under the earlier stated official intentions of “reforming” the pension system.
The markets are already discounting higher risk premiums that are near our 10% to 10.5% targets. However, the underperformance may continue with potential for adverse headline shocks and higher policy risks. The heterodox funding alternatives may reduce near-term financing risks, but, similar to Argentina, may worsen medium-term debt sustainability if the alternatives lower foreign investment, lower growth prospects and yet provide no obvious commitment to fiscal consolidation. The initial reallocation of pension funds would provide only temporary support in front of a declining stock of USD liquidity. It will also be critical to monitor if there if any backlash to investor sentiment with dollarization particularly vulnerable to capital flight that may worsen liquidity/rollover risks.