Panama | Risks of downgrade and supply

Siobhan Morden | January 26, 2024

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. This material does not constitute research.

Debate about relative value continues to dominate the Panama discussion, but it’s equally important to focus on supply and demand. The potential loss of its investment grade rating leaves Panama now trading mostly flat to Colombia. This seems reasonable in the medium term. There are low risks of any crisis that would push Panama to a ‘B’ rating given its strong foreign direct investment and GDP growth. Instead, liquidity has become the focus. The market has to absorb supply from new Eurobond issuance and the potential migration of Eurobonds from investment grade to dedicated emerging markets investors.  This leaves me cautious and looking to the demand and pricing of Eurobond issuance this year as a litmus test.

Panama offers limited data with only quarterly fiscal numbers and scarce economic data for a dollarized country without a central bank. Interpreting the country’s budget management also is difficult with large swings on unqualified (“adjustment”) categories that undermines underlying fiscal trends. The last Article IV report from the IMF encouraged “authorities to work toward SDDS subscription, and stressed the importance of more timely statistics, which would reinforce transparency.” The potential loss of the investment grade status now requires more data transparency, especially on fiscal accounts as the main risk driver for the rating downgrades. The 2024 budget now becomes the litmus test of whether officials can comply with fiscal rule targets.

Fiscal trends are not encouraging. The country ran a structural fiscal deficit of 4% of GDP in 2022—possibly 2023 as well—ahead of an aggressive 2% of GDP fiscal deficit target in 2024. Compliance with the fiscal rule is what’s necessary to anchor debt ratios closer to the 50%-of-GDP threshold for an investment grade rating. The mining closure should have a knock-on impact for both lower growth and forfeited budget revenues (beyond 0.4% of GDP). GDP growth could slow from 6% closer to 4% and debt service rise. The formalization of the mining closure also reduces the chance of new efforts after elections this year to avoid a permanent loss in mining revenues. There isn’t any obvious Plan B for meeting the fiscal deficit target this year, especially on risk of considerable slippage in 2023.

The 2024 budget was revised down from the initial 19% year-over-year increase; however, spending still looks expansionary at 11% year-over-year at a faster pace than 2023. The budget interpretation remains complicated. There is a large above- and below-the-line discretionary adjustment of either a lower budget or higher financing with a relevant swing factor at 2.1% of GDP for the central government budget.  This adjustment factor is much larger in the 2024 relative (2.1% of GDP) to the 2023 budget (0.6% of GDP). This reduces the transparency and increases the execution risks.

Is the central government fiscal deficit budgeted at 2% of GDP or 4% of GDP? This suggests underlying trends for a higher fiscal deficit beyond 4% of GDP and the high risk of loss on the investment grade ratings. It’s not clear whether Fitch will wait until after the elections in May this year or react sooner to the full year fiscal performance in 2023 (February-March 2024). The trends are not optimistic on the loss of 0.9% of GDP in mining revenues and 4.8% of GDP NFPS fiscal deficit through September 2023. The risk of a target miss of 3% of GDP fiscal deficit for 2023 would further undermine the prospects for the 2024 target on lower budget flexibility and higher target rigidity. The back-to-back miss on fiscal targets through 2024 would accelerate the risk of further negative rating action from two rating agencies and a de-indexation from investment grade indices.

The majority of the 2024 financing program depends on external credit.  There is no breakdown between multilateral and market debt on the budget; however, the 2023 debt stock shows global Eurobonds at 75% of external debt. This ratio would imply gross Eurobond issuance at $5.3 billion in 2024 or higher if fiscal deficit errs to the upside. These large financing needs would suggest market issuance sooner as opposed to later with difficulty to postpone market entry until after the July 2024 political transition. The first Eurobond issuance will be critical to monitor with Colombia the peer reference not only on valuations but also the investor reception to the multi-tranche issuance last November. The strong demand for the 30-year debt issuance in Colombia was based on the appetite for high carry on the assumption of relative credit stability after the mature assessment of petro risks.

The context is quite different for Panama. There is still unresolved event risks on the fiscal performance and the rating downgrades, especially the forced selling from indexed investors. This may complicate demand for the higher price premium of a longer maturity bond and push issuance into the crowded 10-year sector of the curve.

The stock of Eurobonds is quite large relative to the size of the country with the challenge of sourcing incremental demand among the emerging markets investor community, not only for the annual large financing needs that exceeds every sovereign credit except Mexico but also for the absorption of the outflows from investment grade dedicated investors. This should require a liquidity premium beyond the ‘BB’ rated peers. The high beta underperformance of Colombia this year pushed the prior flat valuations back to a 30 bp premium of COLOM’37 relative to PANAM’36. This would then infer at least 50 bp to 60 bp new issue premium if not wider depending on demand for 10-year Panama new issuance. The potential mismatch on supply and demand from a declining investor base and heavy Eurobond supply could initially widen spreads beyond ‘BB’ peers. This liquidity premium could increase on successive issuance and argues for a shift in the funding strategy towards multilaterals or other financing alternatives. The market demand also remains a function of broader market appetite with investors the recent risk-off sentiment a less receptive backdrop.