El Salvador: Debt Rating Gets Worse

Two months after reducing the rating from B + to B, Standard & Poor's has now reduced the note to B-, with a negative outlook.

Friday, December 9, 2016

From a press release by Standard & Poor's:

El Salvador's liquidity has deteriorated significantly because of protracted negotiations between the government and opposition parties on a comprehensive set of fiscal reforms that has weakened debt management. The country's fiscal and debt profiles have weakened as a result of the recent political stalemate.

We are lowering our long-term sovereign credit ratings on El Salvador to 'B-' from 'B'.
We are removing the ratings from CreditWatch negative. The outlook is negative, reflecting our concerns about fiscal sustainability and low economic growth for 2017-2019.

On Dec. 8, 2016, S&P Global Ratings lowered its long-term foreign and local currency sovereign credit ratings on El Salvador to 'B-' from 'B'. At the same time, we removed the ratings from CreditWatch with negative implications. The outlook is negative. We also affirmed our 'B' short-term sovereign credit ratings and removed them from CreditWatch negative. The 'AAA' transfer and convertibility assessment is unchanged.

The downgrade reflects a continued erosion of El Salvador's fiscal and debt profiles and raising concerns about its access to adequate liquidity to meet its funding requirements for 2017 and 2018. Recent political agreements between the government and opposition parties could gradually improve the government's access to liquidity to meet its debt servicing needs, including payments due to the country's pension system. The downgrade also reflects the country's weakening prospects for economic growth in a context of lower investor confidence and the need to undertake fiscal adjustment to stabilize the government's growing debt burden.

The delay in gaining Congressional approval for external debt issuance reduced
the government's liquidity, translating into further increases in its already high short-term debt (LETES). The stock of short-term debt has reached $1.18 billion, close to the legal ceiling of $1.3 billion. The recent fiscal agreement in Congress allows for the issuance of up to $550 million of new debt that can be used for repaying LETES, as well as curing growing arrears owed to suppliers and local governments. However, Congress has not approved further debt issuance that would be needed to finance the 2017 fiscal budget.

Accompanying the last debt issuance authorization in November 2016, a Fiscal Responsibility Law (FRL) was also approved with the objective of reducing the
fiscal deficit from an estimated 4.4% of GDP this year to below 3% of GDP over three years. The FRL also caps short-term debt at 20% of current revenues (from 30% currently) and caps total debt at 65% of GDP (or 42% excluding debt issued to fund the country's pension system). We think that it will be difficult for the government to meet these ambitious targets, especially in a context of likely low GDP growth. The recent fiscal agreements between the government and opposition parties in Congress pave the way for a possible agreement with the International Monetary Fund to address the country's weak public finances.

Last year, the fiscal deficit declined to 3.3% of GDP from 3.6% the year before. However, the underlying fiscal position is much weaker as the government has accumulated arrears to suppliers, delays in transfers to local and regional governments as well as payments for subsidies. Considering arrears, the fiscal deficit is likely to exceed 4% of GDP this year and could remain at that level in the next couple of years, absent a substantial fiscal adjustment. The government has limited capacity to raise significantly its revenues, given the large informal sector and many years of poor GDP growth. Weighting on our fiscal assessment is the significant shortfalls in the
country's basic services and infrastructure.

Adding pressure to the fiscal adjustment is the pending pension reform, which is supposed to be discussed over the next year. Annual shortfall of the pension system represented 2% of GDP 2015. Last November, the national court declared as unconstitutional a recently approved change in the pension trust law that allowed the Fideicomiso de Obligaciones Previsionales to fund its maturing obligations to the country's private-sector pension funds by issuing debt. The government will be obligated to make its next payment to the Fideicomiso de Obligaciones Previsionales, due in the first quarter of 2017, in cash, putting pressure on its liquidity.

The general government debt burden has steadily risen in recent years. We estimate that, including pension-related debt, net general government debt could average 66% of GDP for 2017-2019. Also, interest rates have risen significantly over the last year, mainly for short-term debt issuance. We project interest paid to be over 22% of general government revenues on average for 2016-2019.

We estimate that the banking sector and public-sector enterprises pose a limited contingent liability to the sovereign, according to our criteria. El Salvador has a relatively small state-owned enterprise sector, given privatization the sovereign implemented in previous years.

El Salvador's economic growth remains vulnerable to a change in U.S. commercial and migratory policies because the U.S. is its main trading partner 48.4% of El Salvador's exports are to the U.S.), and remittances from the U.S. represented 16% of GDP in 2015. We are lowering our economic trend growth assessment for 2017-2019. Political stalemate has dampened investor confidence, and high crime rates continue to heavily weigh on investments. In our estimations, 2016 real GDP growth will likely moderate to 2.3% from 2.5% in 2015 and average 1.4% for 2017-2019. Additionally, per capita GDP growth would remain at 1.1%, on average, for the same period.

Positive performance in the trade deficit combined with the growth in remittances flows has reduced significantly the current account deficit (CAD) for the first half of 2016. For year-end, we estimate this could narrow to 3.1% of GDP from 3.6% in the year before. Although, exports and remittances could be sensitive to shifts in U.S. policies, which could increase the CAD to 5%, on average, in 2017-2019, according to our calculations. On the other side, we do not expect foreign direct investment (FDI) to pick up in the following years and to remain below 1% of GDP in 2016-2018. We project that El Salvador's gross external financing requirements will average 108% for 2016-2019, and its narrow net external debt could start picking up in 2017, reaching 92% of its CARs.
dollarization has contributed to lower inflation and helped to stabilize the financial system in El Salvador.

However, El Salvador lacks monetary flexibility, leaving fiscal policy as the main tool for economic policy.

The banking system remains well-capitalized, with regulatory capital hovering around 17% since 2010 (16.9% as of June 2016). It is mostly foreign-owned and, at the same time, highly concentrated, with more than 90% of assets held by foreign institutions and six banks holding 84% of system balance sheet. The asset quality of the loan portfolio has improved since midyear--data show a decline in nonperforming loans to 2.1%.

The negative outlook reflects the at least one-in-three likelihood of a downgrade in the next 12 months if continued political stalemate worsens the sovereign's access to funding over the next year, constraining its ability to meet its debt maturities and fund its fiscal deficit. It also reflects our expectation of slow economic growth for 2017—2019. Failure to undertake a timely and effective fiscal adjustment, as well as improve access to liquidity, could result in a downgrade.

We could revise the outlook to stable if successful political negotiations between the government and opposition parties result in an agreement that could lead to a medium-term fiscal adjustment and greater flexibility to meet debt servicing and other financing needs. Staunching the recent deterioration of the sovereign's debt and fiscal profile, as well as its growth prospects, could eventually stabilize the rating at its current level.

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From a press release by Standard & Poor´s:

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