The Big Idea
El Salvador | Limbo
Siobhan Morden | November 12, 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 bonds yields are retracing back to their recent worst levels. The country’s diplomatic tensions with the US are undermining International Monetary Fund relations. And El Salvador still has no alternative medium-term financing plan. These are the things that should eventually undermine what has been a carry trade, with prices bouncing within a narrow range at the lows since late September. The debt looks like a “nervous neutral” at best with a bias to shift back to underweight.
The official admission from the US of difficult diplomatic relations only reinforces the low probability of an IMF program. The economic team has shifted IMF discussions to Washington, DC, this week. However, it’s important to emphasize that an Article IV review is not a loan-funded program, and the economic agenda remains subordinated to the political agenda. There has also been local criticism about the 2022 budget that may push gross financing needs higher with no transparency yet on funding sources. These two themes—IMF relations and funding sources—remain the two main determinants that undermine liquidity, raise solvency risks and explain the continuing distressed yields.
Exhibit 1: El Salvador – Central government sources and uses (excluding pensions)
The recent admission from US Ambassador Manes that diplomatic relations with El Salvador remain “complicated” reaffirms steady deterioration since the country’s autocratic shift on May 1. The intentions of this open admission are not clear. It could be the US is making a more aggressive overture to resolve diplomatic tensions, or it could be a warning that there could be further backlash beyond the individual sanctions from the Engel list. The bottom line is that complicated US diplomatic relations should complicate IMF relations since the US is the largest shareholder.
There are some that argue that more severe budget constraints next year should eventually subordinate politics to economics. There hasn’t yet been any pragmatism from the Bukele administration to address the shortfalls of the autocratic political agenda or any obvious commitment to embrace a coherent economic program. A debt ratio near 100% of GDP requires commitment to fiscal discipline. There is still a high structural fiscal deficit in 2022, and debt ratios are still far from 2019 pre-Covid levels. There is also still the unresolved threat of financial repression and resorting to locals as lenders of last resort. The low LETES amortizations in 4Q21 should provide some near-term relief; however the regulatory restrictions on LETES issuance and the declining demand for CETES issuance are constraints heading into next year.
The well-respected local think tank FUSADES also qualifies the 2022 budget assumptions as unrealistic with bias for much higher gross financing needs next year. The official data shows $1.23 billion in gross financing needs including a fiscal deficit of $718 million, $270 million in external amortizations and $242 million in net domestic amortizations. It’s not clear how they calculate the net domestic amortizations with perhaps full rollover of the stock of LETES but yet $571 million CETES maturing next year. This alone would boost the gross financing needs from $1.23 billion to $1.56 billion. FUSADES also cites a potential $535 million in discrepancies that could push gross financing needs over $2 billion. 1.) Overestimation of tax income, current and “miscellaneous” transfers for $300 million, 2.) Underestimation of subsidies for $38 million, 3.) Underestimation of tax refunds for $62 million, 4.) Lower transfers to the Judicial Branch for $27 million, 5.) Underestimation of payment of interest on short-term debt for $57 million, and 6.) Omission of payment of interest on debt of municipalities for $50 million. It would require overwhelming fiscal discipline to lower spending to compensate against the overly optimistic tax revenue projections.
FUSADES also rightly points out that the budget doesn’t include any efforts for pre-financing the $800 million January 2023 Eurobond amortization. There are two important takeaways: 1.) the structural central government fiscal deficit may be much higher at 4.3% of GDP instead of 2.5% of GDP (ex. pensions) and 2.) there is no transparency on how to finance the shortfall. The reliance on $711 million in multilateral issuance may prove unrealistic and insufficient for budget support while domestic demand may have reached saturation. If the autocratic agenda continues to undermine IMF relations, then the financing could quickly shift into financial repression next year with locals the captive lenders of last resort. This may offer some temporary relief through 2022 but does not provide a financing plan for 2023 including the bulky 2023 Eurobond amortization. This reinforces our “nervous neutral” recommendation with still high liquidity risks and bias towards a shift back towards underweight.