The Big Idea
El Salvador | Liquidity watch
Siobhan Morden | December 3, 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 is showing signs of turning into a pain trade, requiring the country to muddle through and source liquidity to avoid near-term default. The debt needs an anchor after its recent underperformance. El Salvador’s bonds now price well below 70 across the curve and 60 on the longer tenors. The question now turns to how the country muddles through without the International Monetary Fund. Solvency remains a concern over the medium term with on high debt ratios and structurally high public spending. But smaller countries with smaller gross financing needs may be able to muddle through for longer. El Salvador’s ability to source liquidity with BRC-related issuance could be the critical litmus test.
The October fiscal data just released showed the highest fiscal deficit yet this year thanks to financing from local markets and external multilateral funds. Spending remains a problem for a country with deficit financing that accumulates already high debt ratios. This past month there was a shift towards higher capex that perhaps reflects a strategy shift towards a public investment growth model. The success or failure will depend upon the transition from public to private investment-led growth funded from foreign direct investment. This is a high-risk strategy with uncertainty on whether BTC-related investment will commit to a low rated country with weak fundamentals and tense diplomatic US relations. We remain concerned about medium-term debt sustainability. However, the outward-oriented strategy to attract capital may curb more heterodox policies and reinforce near-term willingness and ability to repay debt. There was no forward guidance on a formal IMF program but there was a commitment to maintain normal IMF relations on collaboration and publication of the Article IV review.
There was also no follow-through to nationalize the domestic pension funds. This is logical. The Bukele administration does not have to resort to lenders of last resort if there is still the possibility of sourcing external funds. The markets also probably haven’t grasped the concept that access to external capital also probably reinforces the willingness and the ability to repay Eurobond debt. The access to external credit (even if innovative financial products) emphasizes the importance of respecting financial contracts across products as a pre-requisite for broader external accessibility. The true test depends upon the demand for the BTC-related bond issuance on launch next month. The book size should provide a preview to whether BTC investors could offer a recurrent source of liquidity. This should provide the litmus test on whether sourcing sufficient funds for this year and possibly next year. This would postpone a countdown process on identifying the sources/uses, especially ahead of the bulky $800 million January 2023 amortization.
This may provide some interim liquidity relief; however, there is yet no sustainable path for debt repayment unless there is a positive shock to higher trend growth and/or fiscal consolidation. It remains worrisome that the budget for 2022 could be similar to 2021 and still far from pre-Covid levels in 2019. This runs contrary to the trend of other dollarized countries with the Ecuador 2022 budget not only reverting back to 2019 but exceeding the fiscal performance next year to tackle the higher debt ratios. The alternative sources may finance public spending without contributing to sustainable economic growth. It’ll be important to monitor whether or not the Bukele administration encourages inflows from typically conservative foreign direct investment. There was no obvious vote of confidence from the IMF assessment with warnings on BTC risks amidst an “uncertain” medium term projections of the “evolving policy landscape.” The IMF was also clear about the need for a “well-articulated fiscal consolidation strategy” for cumulative adjustment of 4% of GDP.
The valuation analysis may shift to whether the potential carry compensates against downside price risk. This may dominate over the recovery value assessment if El Salvador can muddle-through beyond the January 2023 amortization payment. The timing of default is the first most important risk factor that remains dependent upon identifying recurrent source of liquidity. The launch of the BTC-related bond issuance in January should set the stage for assessment on near-term liquidity risk. There are no signs yet for a countdown to default with still pockets of liquidity (treasury deposits at the central bank, IMF SDR allocation) and optionality for alternative sources of external funds. The current valuations with bond prices at 60 for the longer tenors (2041 and 2050) now discount a high probability of default with a possible scenario of low recovery value (30-40) but still around three years of coupon payments (20) until the 2025 amortization.