El Salvador | Short squeeze

Siobhan Morden | August 20, 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 has seen a little bounce lately. Initially it came with relief that constitutional reform would retain term limits. Then came encouraging statements from Minister of Finance Alejandro Zelaya downplaying the risk of nationalizing pension funds. But it was the Bitcoin regulations that seemed to offer the most reassurance that the International Monetary Fund program would be back on track. That brought a 2- to 3-point bounce on bond prices. Still, the IMF program is not the base case.

The probability of an IMF program has gone from close-to-zero to around 25%. However, let’s not forget that there is still high uncertainty on US diplomatic relations after the many setbacks since May 1. There has also been no apparent focus on fiscal adjustment. Stimulus and debt ratios are still moving above trend post-pandemic. The IMF program is still not the base case, and high liquidity stress warrants distressed levels. The dominant concern is how El Salvador funds $3 billion in gross financing needs next year and whether the country shifts toward coercive local funding.

The market reaction to the release of the Bitcoin regulations provided some possibility that perhaps know-your-customer data requirements and anti-money laundering guidelines would discourage illicit Bitcoin-related activities.  The ambiguity on whether or not Bitcoin adoption is mandatory or voluntary also suggests that Bitcoin would not be overly disruptive to the broader economy. This may reduce some of the complications that the IMF described as “a number of macroeconomic, financial and legal issues that require very careful analysis.”

The Bitcoin launch on first impression was best-case delays and worst-case a suspension of IMF talks. Even under a best-case scenario, the latest developments do not resolve the more complicated El Salvador and US bilateral relations that have suffered from the May 1 dismissal of the constitutional court justices, the suspension of the CICIES and the refusal to address the corrupt officials within the Engel list amidst the broader concerns about autocracy through plans for constitutional reform. There needs to be some progress on good governance criteria including anti-corruption, institutional transparency, and stronger civil liberties. Let’s also not forget that the fiscal performance through June highlights excess stimulus, with recent spending initiatives that ignore the high 90% debt ratio.  There is still fluid event risk heading into the September 15 bicentennial and the latent heterodox policy risk under budgetary stress in the last quarter of this year.  There is no fast track for an IMF agreement.

Amherst Pierpont’s last few reports have focused on auction watch.  This remains the case on above-trend $173 million LETES maturities this month and so far, only limited $9 million rollover on August 10.  There is a lot riding on the disbursement of a $600 million CABEI loan to make the September 22 maturity of $646 million in CETES. It is worrisome that the size of auctions is declining while rates are edging higher. The locals are typically the lenders of last resort, so the recurrent speculation about nationalizing pension funds is not surprising. If Minister Zelaya wants to convince the market that the country will not nationalize the pension funds, then he needs to clearly identify funding sources for 2022. The shift to financial repression would only backfire on IMF relations, and that would reduce possibilities for a program.  The funding stress late this year should reveal policy intentions, should reveal whether the economic team resorts to coercive financing and should reveal whether this triggers a backlash on domestic market sentiment. Domestic sentiment is critical to determining whether there is contagion to the real economy. On the initial phase of budgetary stress, there are typically pockets of liquidity that perhaps allows for a scraping by through the end of the year.  However, the stakes are much higher for 2022.  The main problem is how the government funds $3 billion in gross financing needs next year without an IMF program, or potentially much larger financing needs if there is rollover stress in the LETES markets.

This reaffirms a cautious view. The short squeeze this week reflects the demand for high carry alternatives; however, there is still significant event risk over the next few months. We’ve adjusted our weighted probability lower to 10.5% on the ELSALV’41 on the following scenarios: 20% * 8.5% (IMF program) + 40% * 10% (muddling-through) + 40% * 12% (heterodox policies).  The persistent Bukele risk premium suggests a higher adjusted yield under an uncertain IMF program while the base case scenario suggests still distressed yields on high rollover and liquidity risks without an IMF program.  The knee-jerk recovery this week seems to underestimate the lingering main concerns heading into the last quarter on the large CETES maturity, stress in the LETES markets and policy risk on bicentennial announcements.