Will El Salvador Default on its Sovereign Debt in 2023?
HODLador-in-Chief Bukele has more options than it seems.
With an $800M sovereign bond due in January 2023 and an implied default probability1 of 48%, international financial markets think there’s about an even chance that El Salvador stops scheduled repayments in eight months, just over a year after adopting bitcoin as legal tender.
El Salvador has stubbornly low economic growth, a wide fiscal deficit and almost 90% of GDP in expensive government debt (costing 5% per year vs 1.5% in the US). Without major changes in economic policy, the country risks a dangerous sovereign default.
Would default tank El Salvador’s economy? Does the country’s use of the US dollar raise the stakes? What role do the IMF, bitcoin and the upcoming presidential elections in 2024 play? Is default inevitable? Find out here —>
Sovereign Default Could be Very Costly.
Most practitioners and academics agree that sovereign default has major costs. This is especially true in dollarized countries like El Salvador, where missed payments by the government could trigger a bank run. Like other emerging markets, local banks, insurance companies and pension funds in El Salvador all have a lot of domestic government debt and some foreign government debt on their balance sheets. Even if President Bukele’s government only defaulted on the country’s foreign debt, the domestic debt would become riskier (and less valuable), causing mark-to-market paper losses across both types of bonds that would eat into bank equity cushions and impair balance sheets across the financial system.
In this scenario, a large minority of Salvadorans might want to park their dollars in physical cash or safe US banks, not in relatively riskier banks at home. Large cash withdrawals or outflows to the United States could strain domestic bank liquidity and potentially tip weaker banks into insolvency. El Salvador’s monetary authority can’t print US dollars to calm a panic or rescue failing institutions (only the US Federal Reserve can), so the central bank would have to use its limited reserves worth $3.4B (or 12% of GDP) to manage the stress.
If this failed, as it could given the central bank’s limited ammunition, El Salvador would have to choose between two unpleasant alternatives: capital controls to stop capital outflows (a dreaded “corralito”) or raising local interest rates to compensate depositors for the extra risk of holding dollars in banks at home. Both options would stall the economy almost immediately. Capital controls stop citizens from moving or spending their money abroad and multinationals from repatriating dividends and high interest rates make home-buying, investment and working capital more costly.
Besides a financial crisis, sovereign default in El Salvador could have other costs. Crucially, debt default might cut off all other external financing, forcing a fiscal adjustment that would impose severe austerity on the country. In a default, multilateral lending from the World Bank and regional development banks CAF, CABEI and IDB might dry up until the country restructures its obligations with bondholders. A dearth of external financing could force the government to cut spending and raise taxes within a year or so to balance the budget, which would also be a major drag on the economy.
The antiquated legal covenants for the $800M bond due in January heighten this risk. The 2023 bonds require 100% of holders2 to agree to any restructuring agreement to resolve a default, meaning that any stubborn bondholder that wants to recover every penny might drag out negotiations, blocking El Salvador from accessing multilateral and capital market financing for years.
Even without all these things, sovereign default would temper animal spirits, especially for foreign investors, who might think twice about investing in a country that doesn’t pay its debts. It would also hurt local importers, who are used to buying on 30- or 90-days credit and may be forced to pay upfront because of the added credit risk of their home country. Given the risks and costs of sovereign default, it makes sense that —>
El Salvador Wants to Keep Paying.
The government appears eager to keep serving the debt, at least for now. In March, the Finance Minister insisted the country’s default risk “is zero” and that the government remains committed to paying in all scenarios. He repeated the same line two days ago. Talk is cheap and governments choose to pay until they don’t, but there are reasons to believe the message is sincere.
For one, President Bukele is looking to get reelected in two years, in June 2024, and govern for another five years after that. His approval ratings are extremely high (85%) and his control over the media and legal system is tightening, virtually guaranteeing a victory at the polls. Still, I doubt he wants to preside over a drawn-out economic slump or financial crisis while on the campaign trail as his government negotiates with creditors to restructure defaulted bonds.
Plus, if El Salvador defaulted, Bukele couldn’t easily blame the past FMLN and ARENA governments for it. The president would spin the story, as he always does, but the fact is that his administration issued over a quarter of all foreign bonds, selling $1.1B of notes in 2019 and another $1B in 2020. Missed payments in El Salvador would also almost certainly draw comparisons to Argentina’s serial defaults and Venezuela’s default in 2017. President Bukele loves spending on price controls and (poorly targeted) subsidies, but he’s still allergic to key figures in the Latin American left (particularly Chavez and Maduro) and may want to avoid the optics of being grouped alongside them.
If President Bukele starts running out of money and has to default, he could do so in 2025, when another major $800M bond is due. But for now, at least —>
El Salvador Can Probably Keep Paying.
For starters, President Bukele could just get a program with the IMF and raise hundreds of millions of dollars in cheap financing to fund the government, which the IMF would gradually disburse in exchange for reforms. The IMF would probably ask for fiscal consolidation (tax hikes and spending cuts) so the debt/GDP ratio trends downwards in the medium run and crypto reform (amending the bitcoin law to contain macro risks). This is all doable. President Bukele has 80% popularity and a large majority in congress. Plus, it's his heavy-handed security policy that has made him extremely popular, not the bitcoin law, which could be changed with limited political repercussions.
If Bukele doesn’t want an IMF program, or just doesn’t want one now, there are a few other ways he could raise money to keep funding the government and stay current on debt payments in the short run. For instance, the country could tap its special drawing rights or SDRs with the IMF (even without a program) by reforming the Central Bank Law or borrow more from regional development banks CAF, CABEI and the IDB.
More speculatively, El Salvador might be able to secure some financing from large players in the crypto space, the so-called ‘whales,’ who want to keep the idea of ‘nation-state bitcoin adoption’ alive. Stable-coin issuer Tether, crypto exchange Bitfinex or others could extend support with a direct loan to the government, by buying domestic bonds or simply depositing dollars in banks in El Salvador, which the banks could turn around and use to buy government debt.
El Salvador could also engage in dreaded “financial repression” to raise financing at home. For instance, President Bukele could use his majority in congress to pass a law to force local pension funds to sell their $1B in foreign assets and use the proceeds to buy domestic government bonds, which would fund the government. Obviously, this would be bad for pensioners.
Another option would be for El Salvador to reduce the reserve requirement ratio for domestic banks, lowering the equity buffer they are required to keep for safety reasons. The government could then force banks (via decree or law) to use the freed-up capital to buy local government bonds, which would raise money to pay the foreign bonds. Obviously, not only would this make the banking system much less resilient in a crisis, it would also crowd out loans to the private sector to fund the post-COVID recovery.
For now, the country has options. None of them are great, but they’re options. All this leads me to conclude that —>
El Salvador (Probably) Won’t Default in 2023.
Some of my readers may be surprised by this not-so-bearish take. In this newsletter, we’ve been very critical of El Salvador, arguing that Bitcoin doesn’t solve any of the country’s important problems. We’ve also been quite harsh about the stalled bitcoin-backed ‘volcano bond’ (e.g. here, here, here, here, here and here). But these are separate conversations.
The country’s experiments with bitcoin don’t change the fact that even without the IMF, the government is probably both willing and able to pay the $800M bond in eight months. Among other things, every bank, pension fund and insurance company in El Salvador has significant exposure to government bonds on their balance sheet, so a sudden default risks a drawn-out economic slump at best and a full-blown financial crisis at worst.
President Bukele is two years away from elections and plans on staying in power for five years after that. This is not investment advice (it never is!), but my gut says that he will avoid default while he can, which includes the next eight months.
The 48% implied default probability for 2023 reflects the perceived risk that Bukele miscalculates ahead of elections. It captures the risk that the President concludes that he is better off stiffing bondholders and spending the $800M at home without considering the pass-through to the domestic economy, the financial system and all the other ramifications. I don’t think this scenario is likely, but it’s certainly worth highlighting.
In any case, what happens after 2023 is anybody's guess3. For now, the big debt repayment in eight months seems more like a 3:1 bet (or so) than the coin toss that markets are pricing.
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The bond is trading for 74 cents and has an assumed recovery value of about 40 cents. It will pay 100 cents plus 5.3 cents in interest in the 8 months remaining to maturity. The implied default probability p can be solved out of this equation: 74 = (1-p)*(100+5.3) + p*40. It comes out to 48%.
This is the relevant excerpt from the prospectus (emphasis mine): “Modifications and amendments to the Fiscal Agency Agreement and the Notes (including the Terms and Conditions) may also be made, and future compliance therewith or past default by the Republic may be waived, with the written consent of the holders of at least a majority in aggregate principal amount of the Notes at the time outstanding, or by the adoption of a resolution at a meeting of the Noteholders held in accordance with the provisions of Schedule 8 to the Fiscal Agency Agreement; provided, however, that no such modification or amendment and no such waiver may, without the written consent or the affirmative vote of the holder of each Note affected thereby”
According to the IMF's Article IV report, without tax hikes and spending cuts, El Salvador needs about $8 billion in net new financing to fund the government through 2026. It’s difficult to see the government scrapping together $8B with one-off measures, financial repression and multilateral financing (i.e. unrestricted budget support, policy loans and partly fungible project loans from the World Bank, IDB, CAF and CABEI). Eventually, El Salvador will need to either slash the fiscal deficit, get an IMF program and recover access to international financial markets at affordable rates or default, only to restructure the economy and the debt.