Moody's Downgrades El Salvador

Arguing a significant increase in liquidity risk and political divisions that are preventing approval of an issuance of long-term debt, the rating agency has downgraded the rating and changed the outlook to negative.

Tuesday, November 8, 2016

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.

The downgrade to B3 is based on the following key drivers:
1) The significant increase in liquidity risks as (i) the government is already under financial stress and has been forced to prioritize payments and (ii) short-term debt continues to rise reaching record-high levels that are starting to challenge local banks' capacity and willingness to absorb additional amounts.

2) The political impasse in the Legislative Assembly that leaves the government without necessary approval to issue long-term debt to retire short term debt and fund its operations.

The negative outlook reflects the risk that an agreement between the main political parties in the Legislative Assembly could prove elusive in coming months further extending the government's funding problems and increasing the possibility of a credit event. Even though Moody's does not rate El Salvador's short-term government debt, the strained fiscal situation may impact the credit profile of the government's long-term debt.

El Salvador's long-term foreign-currency bond and deposit ceilings were lowered to B1 from Ba2. Short-term foreign-currency bond and deposit ceilings remain unchanged at NP.

RATINGS RATIONALE
RATIONALE FOR DOWNGRADING TO B3 FROM B1
GOVERNMENT LIQUIDITY RISKS CONTINUE TO RISE

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.

While the requirement to obtain legislative approval to issue long term debt has been a long standing feature of El Salvador's debt management, administrations in the past had brokered agreements with the opposition to issue long-term debt and retire LETES when the outstanding amount reached around $800 million. Since January 2016, LETES surpassed the $800 million mark, a level at which refinancing conditions began to deteriorate, as they test the absorption capacity of the relatively shallow domestic market. As of October 12, latest data available, LETES had reached a record high of $1.022 billion.

The official limit for outstanding LETES this year is set by the budget at 30% of the government's current revenues year-to-date, that is, approximately $1.3 billion, and higher than the currently outstanding amount. However, the market limit is more relevant in our opinion, determined by the banks' willingness to continue to buy the short-term paper. The increase of LETES beyond $800 million pushed the interest rate the government pays for them to 6.5%, more than double compared to the previous year. Interest rates have been stable since March as the government reached an understanding with local banks to continue to roll-over short-term debt without a substantial increase in interest rates.

However, there is a risk that interest rates could rise further as the appetite from local banks to absorb government short-term debt declines and so does the concentration risk associated with their holdings, potentially making them less inclined to roll over LETES coming due. In a scenario we believe is unlikely, banks could decide to stop rolling over LETES, leading to a default on short-term debt. Although this is not our baseline expectation, the probability of this scenario crystallizing rises as time goes by without an agreement. Our baseline expectation is that if an agreement is not reached and there is no long-term financing to retire any LETES, banks would most likely continue to hold and buy LETES to avoid triggering a credit event. This baseline expectation could shift if it became increasingly unlikely that a political agreement will eventually be reached.

AN AGREEMENT IN THE LEGISLATIVE ASSEMBLY TO APPROVE LONG-TERM DEBT ISSUANCE REMAINS UNCERTAIN

An agreement between the ruling party and the opposition to issue long-term debt to retire short-term debt is crucial to curtail rising government liquidity risks and preserve macroeconomic and fiscal stability. Reaching such an agreement, however, has been difficult due to the contentious relationship between the two main political parties, and their disagreements on policy priorities.

Negotiations have intensified in the last couple of weeks, with a meeting between President Sánchez Cerén and the new head of opposition ARENA party, Mauricio Interiano. Such engagement at the highest level of authority reflects the urgency of the situation, indicated by pressure to resolve the impasse from various stakeholders including municipalities, suppliers and local banks.

RATIONALE FOR THE NEGATIVE OUTLOOK
The negative outlook reflects the risk that an agreement between the main political parties in the Legislative Assembly could prove elusive in the next months, failing to normalize the funding situation of the government and further straining its liquidity position.

WHAT COULD CHANGE THE RATING UP/DOWN
Given the negative outlook, an upward movement in the rating is unlikely at this time. The outlook could move to stable if the government is able to materially reduce government liquidity risks. The reduction of liquidity risks could come in the form of an agreement between the FMLN and ARENA to approve long-term debt issuance, sufficient to retire a portion of short-term debt paper and reduce arrears. In addition, a credible plan for addressing the government's persistent budget deficits and rising debt ratio, in the form of a fiscal responsibility law agreed between the main political parties or under an IMF program, would be supportive of the stabilization of the outlook.

We would downgrade El Salvador's B3 ratings if it appeared unlikely that an agreement allowing the government to access long-term funding would be reached early next year, since this would materially increase the probability of a credit event. Even though Moody's does not rate El Salvador's short-term government debt, the further escalation of financial stress would impact the credit profile of the government's long-term debt.

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