El Salvador Announces Plans for Debt Repurchase
How might it play out? What does it mean?
President Nayib Bukele of El Salvador made big news today. In a series of tweets, he announced that his government plans to send two bills to congress to authorize funding for a debt repurchase of the country’s sovereign bonds maturing between 2023 and 2025. In six weeks (or so), he will begin to repurchase sovereign debt at its market price at that time.
It’s not immediately clear if he is only referring to the two large NY law $800M foreign bonds maturing in January of those years (largely held by hedge funds and emerging market funds), or if he is also referring to the local law domestic debt (largely held by domestic banks and pension funds). I’m assuming he is talking about the foreign bonds, but I could be wrong.
In any case, this news has major implications for El Salvador’s future in the traditional financial system and the probability of sovereign debt default. For once, I think this is good news for Salvadorans —>
Traditional Finance
I’ve written a lot about El Salvador, the first country in the world to adopt bitcoin as legal tender last September. In late 2021 and early 2022, when bitcoin was above $60,000 and the billion-dollar bitcoin-backed Volcano bond was arguably a real possibility, it seemed possible that President Bukele might succeed in breaking away from the traditional financial system. It seemed possible that he might raise big financing from crypto and free himself from the fiscal discipline imposed by traditional debt markets and multilateral lenders.
But with crashing crypto prices and fading enthusiasm, all that passed, for now at least.
With the offer to repurchase the country’s outstanding bonds, President Bukele is reaffirming that sovereign debt issued in the traditional financial system is both real and worth paying. He is reasserting his commitment to pay the country’s debts, even if he is hoping to repurchase 23 and 25 bonds for less than their full face value. This doesn’t mean he is walking back crypto (at all). But it does signal he is still a participant of the traditional financial system.
Sovereign debt analysts typically look at different countries' ability to pay and willingness to pay to assess the likelihood that they will continue to make debt payments. Today, El Salvador’s willingness to pay has been explicitly affirmed by the head of state. The announcement also suggests that capacity to pay is perhaps better than it looks, at least in the short run, as I have argued before.
Game Theory
How will this tender offer play out? It’s complicated.
The 2023 bond was trading at 76 cents on the dollar and recently jumped to 90 with this news, while the 2025 bond was trading at 36 cents and jumped to 50 cents. The bonds may rise in price some more in the coming weeks as more details about the announced tender offer emerge, making the debt buyback more expensive for the government.
Once the tender offer is formalized, each bondholder will be faced with a choice: either sell their 2023 (or 2025) bonds early for a guaranteed price lower than 100 cents on the dollar, or hold them until maturity for a good but not guaranteed chance at recovering the full 100 cents on the dollar.
In some sense, the best outcome for any individual bondholder is for everyone else to sell their bonds to the government, lowering the probability of default in the next few years as much as possible, and then to do nothing except wait until January 2023 and 2025 to receive the full 100 cents on the dollar at maturity and the annual coupon (interest) payments along the way.
This strategy is also risky, though. As recently as yesterday, people thought there was a roughly 40% chance of a sovereign default in El Salvador in six months. The probability of default before 2025 was much higher. Clearly, holding to maturity still risks default. A large debt repurchase will lower the default probability of the remaining 2023 and 2025 bonds, but not by that much.
Even if the government meaningfully reduces debt payments for 2023-2025, external shocks or crises or the government’s own fiscal policies could destabilize the country’s finances. Many bondholders, particularly the risk averse, may want to take this opportunity to offload the risk on their El Salvador positions early.
All this can be formalized in a game theoretic model with equations and such. But ultimately, there will be two opposing forces at play. Some bondholders will want to hold to maturity, stomaching the risk that the government doesn’t pay. And some will cut their losses and take this guaranteed payout rather than ride out the uncertainty for another six or thirty months.
How much debt the government is able to "write off" will depend on how these countervailing forces balance. The dynamic will determine the equilibrium quantity of tendered bonds and the price at which they will be tendered.
Bondholders may also try to communicate and coordinate to ensure a good outcome for themselves, although the payoff for ignoring other bondholders and ‘free riding’ until maturity will be significant for some, I suspect.
Good for El Salvador
There’s still much to learn about how the debt repurchase will play out. It’s unclear how much debt El Salvador will be able to re-purchase out of the $1.6B foreign 2023 and 2025 bonds I’m assuming will be eligible. And it’s not clear for how deep a discount to face value the country might be able to re-purchase these bonds. Still, if executed properly, this tender offer could save Salvadoran taxpayers good money by wiping out scheduled principal and interest debt payments. That’s good.
I once wrote that President Bukele might try a similar debt repurchase but in secret, not because I thought El Salvador should do it but because I thought they might be tempted to, given the economics and the potential to wipe out a lot of debt for cheap. This is the traditional version of the proposal.
I’m cautiously optimistic here.
Cautious, because the debt repurchase doesn’t change that El Salvador has an unsustainably large fiscal deficit that will require painful tax hikes, spending cuts or both to address. Cautious, because the country’s debt is still large and expensive. Cautious, because a planned debt repurchase is not the same as a credible plan for fiscal sustainability. And cautious, because El Salvador’s access to new, fresh financing from bond markets will likely remain cut off until serious fiscal reforms are undertaken.
But I’m also optimistic. The move could save taxpayers real money, perhaps a few percent of GDP at most, depending on the outcome of the tender. And the move signals that President Bukele’s government is more serious than it was yesterday about averting a potentially destabilizing debt crisis and managing the macroeconomy responsibly.
(Note: After sending out this post, I learned that the funding for the repurchase will likely come from heterodox sources, notably the IMF Special Drawing Rights (SDRs) held by the Central Bank. If true, this will weaken central bank independence, which is obviously risky and dangerous. More commentary on this on twitter later).
the perfect storm is looming over el salvador. although the probability of default on the nation's sovereign debt has been increasing from mild to high to probable; the fact that the president is seeking reelection in less than two years plays a major role in the course of events in the short term.
let's not overlook, however, the fact that nayib bukele is very corrupt and very deceitful. so much so that there is reason to suspect he has colluded with high profile crypto promoters like stacy herbert, max keiser and some companies from the crypto ecosystem like bitfinex and tether to intentionally degrade the country's bonds down so his partners can buy them at pennies on the dollar and later rebuy them at a higher price but still somewhat lower than face value. if those suspicions were accurate, i wonder if under NY law the SEC and other authorities could step in and open an investigation for insider trading?
the main point still remains the same; the 2023 and 2025 bonds are crucial because they mature right in time of the president's reelection and as i've mentioned before for nayib bukele, his siblings and close accomplices reelection is a matter of survival because once they leave office the risk of being arrested, extradited to the united states and sentenced to life in prison for drug trafficking, money laundering, obstruction of justice, terrorism, etc. is likely. so the salvadoran government cannot afford to fall into default and risk the economic shockwaves of such an event. nayib bukele is aware of what happened to the president of sri lanka recently and is terrified of any event that may lead to his removal from office.
the move to rebuy the debt before it matures is a good one but only in the short term and for the reasons mentioned above. but if you look at it in the mid to long term it is not good. even if the country does not go into default in 2023 and 2025, once nayib bukele has established himself in power indefinitely he can thus afford to not pay the foreign debt beyond 2025, he would have no incentive to pay. another factor to consider is that investors who lose money by selling short of the bond's face value will not easily invest in el salvador again, at least not anytime soon because, well, from the negative experience of uncertainty. that means that the country will continue to isolate itself from international, traditional sources of financing while the deficiency of corrupt practices internally continue to wear on the population while the fiscal deficit continues to grow and the economy stagnates. eventually nayib bukele will have no option but to use cruel, brutal repression to keep an ever growing popular discontent that threatens to oust him from power. that means a great danger looms over the country for the years beyond 2025 and prospects remain gloomy at best.