The Big Idea
El Salvador | IMF optionality
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Recent returns in El Salvador sovereigns have lagged this month against credits like Ecuador and Argentina. The credit these days is driven by events and awaits clarity on relations with the International Monetary Fund after the optimism last month. Recent IMF communication suggests commitment to finalize almost 12 months of on-again-off-again negotiations, maybe over the next three to six months. Recent economic slowdown and cash flow stress should prompt a resolution sooner as opposed to later. An IMF program would possibly open capital markets and reduce liquidity stress but also help business and consumer confidence.
The markets appear pessimistic based on the 60% probability of an IMF program implied by the weighted binary outcome on current valuations. This seems to reflect more the fatigue of the protracted negotiations and not the increasing motivations to close a deal. The recent IMF communication is a reminder about the optionality of surprise positive headlines on behind-closed-door negotiations.
Eurobond yields remains in limbo in a trading range, awaiting clarity on IMF event risk and a recent pullback after the optimism last month. The clock is ticking with the latest IMF communication suggesting final phase of negotiations. Are the markets skeptical or hopeful for an IMF program? The event risk is binary but it’s easier to assess valuations under best as opposed to worst case scenarios.
Our base case view assumes an IMF program. The headline confirmation should push yields towards 9% on unwinding the deal risk and assumption of low execution risks. The IMF program should assume only low execution risks under the commitment and centralized decision-making process of the Bukele administration.
The motivations to agree to a program are the same motivations to deliver on the program targets. This should anchor yields closer to normalized levels of 9% on lower liquidity and gradually lower solvency risks. The proxy to the ~9% yields in the Bahamas seems reasonable although not an ideal comparison on few stressed (as opposed to distressed like Ecuador and Argentina) credits in the region.
It’s more difficult to conceptualize valuations under the alternative scenario without an IMF program. The willingness to pay remains a strong anchor after the bond buybacks in September and December 2022. Eurobonds remain priority payments with a track record of honoring debt even through higher cashflow stress. This alone would suggest firm support at the post buyback price levels near 50 under a no IMF scenario. This is an extremely conservative assumption that doesn’t incorporate a scenario of an alternative unilateral fiscal adjustment without the IMF. The other optimistic alternative is that the Bukele administration muddles through and slowly adjusts the fiscal deficit on their own. The implied probability of no IMF (14.7%) under conservative assumptions and yes IMF (9%) suggests a 40%/60% weighted ratio at current yields of 11% on the ELSALV’50. This seems too cautious after the recent IMF reaffirmation of goodwill, progress on negotiations and still a reasonable 3- to 6-month window to finalize a program. The IMF confirms progress on several areas with both sides still needing to find a compromise solution for Bitcoin.
The motivations are now arguably higher to reach an agreement. 1.) There has not been much fiscal adjustment with still large financing needs. The latest fiscal data through July show a slight deceleration on the 12-month rolling deficit but still a notable deterioration compared to 2022-2023. The tax collection remains impressive but recent higher transfers offset the deceleration in wages. The higher severance payments for layoffs explains some of the recent deterioration on the fiscal accounts with a temporary setback but potential for permanent savings. 2.) There have been no alternative financing sources to sustain a protracted cashflow deficit. The exposure of domestic banks has been stagnant at 12% of total assets from August 2023 through June 2024 while foreign exchange reserves remain low. The escalation in pension debt suggests their role as a primary funding vehicle but its unclear how many more funding capacity remains. And maybe most importantly, 3.) the recent economic deceleration looks quite worrisome with a net 0.8% year-over-year average contraction in the second quarter of 2024. There is no margin for counter-cycle fiscal stimulus but rather argues instead for a positive shock and near-term financing from an IMF program. The optionality for an IMF program still remains the base case scenario, especially after the recent official communication and the lower policy flexibility.
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