El Salvador | No longer distressed

Siobhan Morden | August 4, 2023

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.

Spreads on El Salvador’s longer debt have now quietly slipped below 1,000 bp, the usual threshold of distress. The stealth outperformance is probably based more on technicals than fundamentals, with strong investor interest in high carry. El Salvador has been a clear relative value this year but now reaches a mature phase of recovery. Appetite for carry may still push prices marginally higher, especially with illiquid secondary markets sensitive to investors covering underweight positions. But solvency is still an issue based on low growth prospects and a harder phase of fiscal consolidation. This leaves the country’s bond prices increasingly vulnerable to downside.

Near-term price stability reinforces the carry trade. The country’s liquidity remains manageable despite slowing revenues with incremental cash following pension reform and fiscal restraint. Flat revenues translate into flat spending for the first half of the year. Lower transfers offset continuing high debt service. There is some budget flexibility with a political agenda that allows for lower regional transfers after the recent municipality re-zoning and strategically ahead of the elections. Debt service remains a priority, with debt buybacks last year showing commitment to pay and a smoother debt repayment profile through 2025. This perpetuates the muddling-through carry trade for now. But there is still high uncertainty around longer-term debt payments.

The fiscal accounts have reached a slower and more difficult phase of adjustment.  The latest data for the first half of the year shows a similar performance to last year and a clear reversion from the pronounced deficits in 2020 and 2021. However, the latest data show somewhat of a plateau with a 12-month rolling deficit of $592 million through June and mostly unchanged against December last year. This slowdown of fiscal consolidation could represent a logical pause to avoid pro-cyclical adjustment ahead of the elections next year. The Bukele administration probably doesn’t want to undermine the slow recovery in economic activity at an average rate of 3.7% year-over-year in May through June after 2.3% year-over-year from January through March.

Workers’ remittances remain resilient; however, the breakdown of the balance of payments flows are not ideal for trend growth. The current account deficit and import consumption was financed last year with lower reserve requirements (foreign exchange reserve loss), other investments (multilateral loans, trade financing and so on) and errors and omissions. These funding sources are increasingly scarce, especially as foreign exchange reserve requirements reach historic lows. If there are no excess dollars to fund consumption, then growth prospects could remain suboptimal at 2% GDP or lower. There has been a recent pickup in tourism inflows and information technology services but nothing transformational. There is clear vulnerability to external trends that would only exasperate pro-cyclical fiscal austerity. The recent tighter credit spreads also do not yet open capital markets. Yields remain in the 12% to 14% range with estranged relations with the International Monetary Fund and restricted access to multilateral loans.

There is still political flexibility under the autocracy of the Bukele administration and high approval ratings heading into the election cycle. Low near-term debt payments allow for a slower phase of fiscal consolidation especially under the budget flexibility of municipality transfer cutbacks and the financing flexibility of pension reform. The muddling-through on low liquidity risks may support a tactical carry trade near-term; however, its increasingly difficult to rationalize much higher bonds prices under a scenario of paying for longer beyond 2027.

There are large Eurobond amortizations in 2027 with still no medium-term debt repayment plan. There is (yet) no virtuous circle that validates much higher bond prices. Instead, there is the same low conviction on a medium-term debt repayment under low 2% trend GDP growth, low financing alternatives and a fiscal deficit of 2% of GDP. This logically only validates near-term carry returns with current bond prices facing increasing resistance at higher levels for still unresolved solvency risks.