El Salvador: Moody's Downgrades Rating to B1

The government's inability to stop the growth of debt in the context of low economic growth and a high fiscal deficit is the reason for the reduction in the rating.

Friday, August 12, 2016

From a press release by Moodys:

New York, August 11, 2016 -- Moody's Investors Service has today downgraded El Salvador's issuer and debt ratings to B1 from Ba3 and placed the ratings on review for further downgrade.

The key driver for the downgrade to B1 is the continued inability of the authorities to arrest the upward trend in government debt amid persistently high fiscal deficits and low economic growth.

Moody's review for further downgrade will assess the rising government liquidity risks derived from persistently high and rising short-term debt in a relatively shallow domestic market, and the legislative impasse that has so far this year prevented the approval of long-term debt issuance to retire short-term paper. The review for further downgrade will allow Moody's to better assess rising liquidity risks in El Salvador's credit profile and explore possible scenarios that could materialize, depending on the government's policy response and the outcome of negotiations between the main political parties in the Legislative Assembly to normalize the funding situation and, ultimately, avoid a credit event.

Moody's would downgrade El Salvador's B1 ratings if the review were to conclude that measures are only sufficient to temporarily curb the increase in liquidity risks. In this case, the most likely rating outcome is a one-notch downgrade. However, if government liquidity risks continue to rise unabated and an agreement to approve long-term debt issuance to retire short-term debt remains unlikely, a downgrade of more than one notch would be possible.

El Salvador's long-term foreign-currency bond and deposit ceilings were lowered to Ba2 from Ba1. Short-term foreign-currency bond and deposit ceiling remain unchanged at NP.

RATINGS RATIONALE
RATIONALE FOR DOWNGRADING TO B1 FROM Ba3
GOVERNMENT EFFORTS HAVE FALLEN SHORT IN ADDRESSING THE RISING DEBT TREND

Moody's decision to downgrade El Salvador to B1 was driven by the continued inability of the country's authorities to arrest the upward trend in government debt amid persistently high fiscal deficits and low economic growth.
El Salvador's government debt ratios have reported an upward trend since 2009 driven by fiscal deficits of around 3.6% of GDP, which, in addition to pension-related expenditures, have been due to an expanding wage bill and untargeted subsidies. Moody's expects debt-to-GDP to surpass 60% by year-end 2016. GDP growth of only 2% implies that a stabilization of debt ratios requires the authorities to implement aggressive fiscal consolidation measures involving both revenues and expenditures. Political gridlock in the Legislative Assembly and a lack of a majority by the ruling party make this task particularly challenging.

As a result of a slow but steady rise in debt metrics, government finances are weaker than those of other sovereigns in the Ba category. El Salvador's debt-to-GDP ratio is 15 percentage points higher than the Ba median projected to be 47% in 2016. The government's interest burden (interest payments-to-government revenues) is 4 percentage points higher than the Ba median (12.7% vs. 8.7%). Low GDP growth complicates the government's fiscal consolidation efforts given average annual growth of 1.7% over the past decade, which compares to 3.7% of the median for Ba-rated peers over the same period.

If current fiscal and economic trends continue, without a fiscal or pension reform, we project the gradual rise in the debt-to-GDP ratio to continue and to approach 70% by 2020.

The affirmation of the Ba3 ratings last November incorporated Moody's expectation that the government would take steps to reduce fiscal deficits and stabilize rising debt ratios. The rating agency expected this would be supported by approval of a pension reform. Since then, the government has been unable to reach an agreement with the opposition, and its efforts were sidetracked because the ruling party (FMLN) lost support from its main ally GANA, the third largest party in the Legislative Assembly. Without GANA's votes, it is unlikely the FMLN will obtain the necessary votes to approve a pension reform given strong opposition from ARENA, the opposition party with the most seats in the Assembly.

El Salvador's pension system was privatized in 1998 and moved to a defined-contributions system. However, the system partly operates as a pay-as-you-go system with a portion of current pension obligations financed by the government's budget, while most of the contributions accrue to the private pension funds for future pension payments. Moreover, legislative decisions over the past decade to increase benefits under the private system, to make it match the old system, have increased the financial costs of the transition period. According to government estimates, pension-related government expenditures have hovered at around 1.8% of GDP during 2005-15 and are expected to remain roughly the same during the next decade. The accumulation of these annual pension outlays has led to a steady increase in debt issued to fund pensions, which now amounts for 13.8% of GDP.

Pension expenditures represent roughly half of the fiscal deficit. Without addressing pension-related fiscal costs, any single fiscal effort will have only a limited effect in arresting the debt trend.

RATIONALE FOR THE REVIEW FOR FURTHER DOWNGRADE

Moody's decision to initiate a review for further downgrade of El Salvador's B1 rating is intended to allow the rating agency to better assess rising liquidity risks in the country's credit profile. The review also offers Moody's the opportunity to explore possible scenarios that could materialize depending on the government's policy response and the outcome of negotiations between the main political parties in the Legislative Assembly that could ease funding pressures and, ultimately, avoid a credit event.

The government of El Salvador faces increased liquidity risks, given the continued rise of short-term government paper (LETES) which currently stands above historical thresholds, challenging local banks' capacity and willingness to absorb additional amounts. As the government has been unable to secure approval from the Legislative Assembly to issue long-term debt, it has been forced to increasingly finance itself with short-term debt. As a two-thirds majority vote in the Legislative Assembly is required to approve long-term debt issuance, the ruling party (FMLN) needs support from the main opposition party (ARENA) to get approval.

Previous administrations had always been able to broker an agreement with the opposition to issue long-term debt and retire LETES when the outstanding amount reached $800 million. Since January 2016, LETES surpassed the $800 million mark, a level at which refinancing conditions began to deteriorate. In March, LETES reached a record high of $937 million and then declined to $857 million in May as the government restrained spending and benefited from strong revenue collection.
To date, there are no indications that an agreement between the two main parties will be reached soon.

WHAT COULD RESULT IN A FURTHER DOWNGRADE

Moody's would downgrade El Salvador's B1 rating if the review were to conclude that an agreement between the political parties, or other government measures, are only sufficient to temporarily curb the increase in liquidity risks, provide temporary breathing room to government finances, and therefore delay a comprehensive agreement on fiscal and pension reforms. The most likely rating outcome in that instance would be a one-notch downgrade. However, if government liquidity risks continue to rise unabated and an agreement to approve long-term debt issuance to retire short-term debt is unlikely before the end of the year, a downgrade of more than one notch is possible.

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From a press release issued by Moody's:

New York, November 07, 2016 -- Moody's Investors Service has today downgraded El Salvador's issuer and long-term debt ratings to B3 from B1 and assigned a negative outlook to the ratings, concluding the review for possible downgrade initiated on 11 August.

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