The Big Idea
El Salvador | High market sensitivity
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El Salvador remains vulnerable with recent underperformance to less liquid ‘B’ peers like Honduras and the Bahamas on the latest bout of emerging markets weakness. The country’s relative value metrics have reached their worst level this year. The IMF program is not yet anchoring the sovereign and whispers of new issuance challenge the market’s earlier assumption of no issuance until 2027. The country will need to deliver on the IMF program to realize potential higher foreign direct investment and trend growth. This should put in motion the gradual virtuous circle of lower market sensitivity, credit rating upgrades and tighter credit spreads.
The IMF program still needs maybe another quarter of compliance to counter skeptics. The release of June fiscal data at month end will be critical for reaffirmation of second quarter performance. The markets are still optimistic after outperformance in the first quarter. However, the fiscal accounts still need to show a track record on the frontloaded 1.7%-of-GDP fiscal adjustment this year. The April and May data show a curious spike in current spending. The release of the June data has to show spending restraint and an aggressive reversal from the higher-than-expected spending in April and May.
There is no room for any slippage with fiscal discipline the crux of any IMF program and the eventual solution to high debt ratios. The IMF reiterates that “continued adherence to the 2025 fiscal targets remains essential.” The IMF also remains confident, noting “They remain deeply committed to meeting the fiscal targets and stand ready to make additional spending adjustments if needed.” The request for fiscal contingency measures and proposed tax measures shows low tolerance for any target deviations. The fiscal anchor is critical for lowering the cost of financing and attracting foreign direct investment for economic growth.
The lessons learned from Argentina under President Macri is that conservative foreign direct investment inflows are typically “last movers” at an advanced stage of economic stabilization. The foreign direct investment inflows are accelerating but are not yet transformational at just under 2% of GDP. This compares to the inflows of 3% to 4% of GDP among high growth peers in Central America. The economic growth also remains sub-optimal at 1.7% year-over-year from January to April this year. This compares to a regional average closer to 3.5% and a threshold of pain of 2.5%.
The workers remittances, growing at an above trend 19% year-over-year in the first quarter, remain the highest US dollar inflow across the balance of payments and provide the primary funding for imports and other US dollar liabilities. The extension of the TPS should provide some breathing room to El Salvador migrant workers relative to Honduras. However, tighter borders will still reinforce the needs for domestic employment opportunities. The tourism industry is the obvious strategic area for foreign direct investment inflows and also a growing contributor for US dollar inflows at 6.5% of GDP in 2024.
“The government is implementing a Long-Term Growth Strategy aimed at removing impediments to growth through government interventions and private sector engagement,” the IMF writes. “The authorities have identified—by combining tools from growth diagnostics, economic complexity analysis, and liaison with the private sector—tourism, pharmaceuticals, and high value-added manufacturing (computers, electronic and optical products) as key areas. These industries were selected considering their export potential and their proximity to products already produced in El Salvador.”
The commitment from long term capital will require the commitment from the Bukele administration to a successful IMF program. There is significant potential for foreign direct investment inflows into El Salvador under the advanced highway infrastructure, best regional security, and business friendly pragmatic Bukele administration. The IMF also recommends upgrading infrastructure, reducing regulations, and increasing human capital to reduce the bottlenecks for higher growth potential. The private sector is the obvious partner through PPP or other more efficient vehicles under the budgetary capex constraints. This should also allow for a gradual cycle of credit rating upgrades and lower market sensitivity across the Eurobonds that would assist the virtuous circle of higher growth.
However, the near-term technicals still dominate in light of only gradual credit improvement. The anchor is not only the reassurance from an IMF program but also the technical benefit of a small stock of bonds that minimizes market sensitivity. The current IMF program assumes no external market access until 2027 under a fully funded program with multilaterals, bilaterals and local markets. If there were any attempt to re-open the markets with new Eurobond issuance, then there are various fundamental and technical repercussions.
The new issuance would have to comply with the net borrowing requirements and maybe also intend to reduce the high debt service at 4.7% of GDP. The prospects for debt liability management would be welcome. However, any incremental net Eurobond supply would maybe require a supply risk premium and increase market sensitivity. The El Salvador Eurobond curve shows much higher sensitivity on the more liquid longer tenors that have digested $2.9 billion in new issuance in 2024. The new issuance would widen the liquidity premium relative to peers considering the $6.4 billion stock of Eurobonds in El Salvador against $2 billion in Honduras and $2.5 billion in The Bahamas. The higher liquidity may heighten the volatility and undermine the carry trade relative to illiquid peers.
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