El Salvador | Course correction

Siobhan Morden | July 30, 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 near distressed yields on El Salvador’s debt suggest increasing default risk. But there are certainly no plans for that. The possibility of alternative domestic financing has come up, and the country has no track record of default since 1993 aside from a 2017 local pension bond accident. The annual Eurobond coupon payments are quite low at $581 million with relatively small gross $2 billion to $3 billion of financing needs.  If the risk of default from liquidity stress is low, then it is more a question of default from solvency stress.  The high 90%-of-GDP debt ratios are vulnerable to further deterioration if there is no commitment to fiscal discipline or no growth.  El Salvador’s reaction to funding stress and perhaps broader financial market stress in the fourth quarter of this year should provide important guidance to the country’s future.

It is still difficult to understand President Bukele’s reaction function.  It is not the interventionist public consumption growth model like Correismo or Kirchnerismo. Pre-emptive default would certainly not coincide with a strategy to seek international prestige and legitimacy. There is a clear focus on technology as the potential engine of private growth. However, there has not been much if any improvement on reigning in public spending, and the political agenda seems to discourage private investment. Politics continue to dominate, which may bias the Bukele administration towards spending while also creating tense US diplomatic relations that makes an International Monetary Fund program more difficult.  The pursuit of corrupt opposition politicians seems more a political than anti-corruption, with yet no reaction to the Engel list designated corrupt officials within Bukele’s own administration.  There is a clear incompatibility between the economic and political agendas that should reach an inflection point under worse budget stress. This is not a stable equilibrium.

If the Bukele administration adopts a more heterodox bias towards coercive domestic financing, then this raises the risks of worse medium-term debt dynamics.  The policy heterodoxy could undermine investment while perpetuating fiscal laxity and continuing to pressure debt dynamics.  The longer the Bukele administration pursues suboptimal policies then the higher the risk of medium-term default.  The bottom line is that the unpredictable and improvisational policies undermine investor confidence while Bukele’s political agenda may continue to undermine fiscal discipline.

There has already been a popular backlash to the BTC proposal with a recent decline in Bukele’s popularity rating. So far there have been no signs of pragmatism or backtracking from policy mistakes. The monthly fiscal data continues to show a bias for higher spending with recent BTC and minimum wage announcements reaffirming spending bias as opposed to prior IMF-related discussions of tax hikes.  The risk is that it will be harder to adopt fiscal austerity into weaker approval ratings, especially if priority shifts to a constitutional referendum that seeks mandate for re-election.

There is a clear inconsistency between pro-growth economics and autocratic politics for a small, open dollarized economy. How will the Bukele administration react to financial and budget stress?  The “course correction” requires pragmatism, which seems to contradict the autocratic style, while a creative compromise seems difficult without a team of technocrats.  This is not a good combination, and this is why it becomes increasingly more difficult without an IMF program.  The high 90%-of-GDP debt ratios remain the priority concern and primary vulnerability if the Bukele administration shift towards policy heterodoxy.

The alternative path away from the IMF suggests higher medium-term insolvency risk with the increasing budget stress in late 2021 the next test.  The market cannot rule out latent pragmatism if ultimately the subordination of the economic agenda triggers crisis.  The potential for financial stress or intense budget stress maybe motivates a “course correction.” There has been the beginning of financial stress on slightly higher rates and lower demand in LETES auctions, but no deposit flight and not the same pass-through of stress from Eurobond markets.

It is near impossible to have a 2- to 3-year view on what remains a fluid situation; however, investors should remain bearish on the next 3-month interval. There is the possible unwind of the IMF option and an overhang of long positions that risks a re-test to the former 10% to 10.5% worst pandemic levels. The financial and budget stress may be the necessary catalyst for a “course correction,” with a reactive approach that validates an underweight recommendation.  It might have to get worse before it gets better.