Press Release: Fitch Affirms El Salvador’s IDRs at ‘B+’; Outlook Stable
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Fitch Ratings-New York-07 July 2016: Fitch Ratings has affirmed El Salvador’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at ‘B+’ with a Stable Outlook. The issue ratings on El Salvador’s senior unsecured Foreign- and Local-Currency bonds are also affirmed at ‘B+’. The Country Ceiling is affirmed at ‘BB’ and the Short-Term Foreign-Currency IDR at ‘B’.
KEY RATING DRIVERS
The B+ ratings are supported by El Salvador’s macroeconomic stability underpinned by dollarization, adequately capitalized banking system and solid sovereign repayment record. The country has higher income per capita, and social development and governance indicators than peers. On the other hand, the ratings are constrained by El Salvador’s rising debt burden and growth underperformance relative to peers, political polarization; prolonged periods of congressional gridlock, and weak business confidence which hinder progress on reforms to arrest the deterioration of public finances and improve the business environment.
El Salvador’s GDP growth remains low compared to that of its peers, with five-year average GDP growth at just 2% compared to a ‘B’ median of 4.1%. El Salvador’s growth picked up to 2.5% in 2015 from 1.4% in 2014. However, the improved growth rate is insufficient to generate employment, reduce poverty or stabilise the general government debt dynamics. Political polarization, security concerns, and high emigration levels undermine the business climate and hinder investment prospects and growth.
The general government deficit improved in 2015 with a deficit of 3.3% of GDP, down from 3.6% of GDP in 2014. However, the deficit is expected to widen to 3.5% of GDP in 2016. The relatively high deficits and weak growth are leading to a steadily increasing debt burden to an expected 62% of GDP in 2017 absent fiscal reform, from 60% in 2015 and 58% in 2014. Furthermore, the interest burden is expected to continue to rise as well, growing to nearly 14.5% of revenues in 2017 from 12.4% in 2015.
The political polarization between the government and the main opposition Arena party has prevented the government from issuing external debt since September 2014. A 2/3 majority of the Congress is needed to authorize external debt issuance, requiring agreement from the opposition. As a result, the government has relied mostly on the issuance of local short-term debt (Letes), which reached nearly $900 million as of end-May 2016. The legal limit of Letes issuance for 2016 is $1.33 billion. The rise in the stock of Letes has pushed local interest rates up to over 6%.
Fitch’s base case is that the government will reach an accord with the Arena party to obtain authorization for external debt issuance. Fiscal adjustment would be needed to arrest the steady increase in the debt burden but political tensions pose risks for progress on fiscal consolidation and growth-enhancing measures.
El Salvador lacks a medium-term fiscal framework that would reduce the fiscal deficits and stabilize the debt dynamics. The Congress is discussing several proposals to adopt a Fiscal Responsibility Law aimed at a rules-based mechanism to reduce the fiscal deficits over time and stabilize or reduce the debt burden over time. Additionally, the government proposed a new pension reform in February 2016 that aims to create a so-called mixed system under which part of the private pension funds would be transferred to a public pension system. If approved, the proposal could reduce the deficit associated with pension costs and reduce the government’s debt burden over the short term (however, without parametric reforms, the deficits would grow again over the medium- to long-term).
El Salvador has become increasingly dependent on external borrowing to finance current account deficits. However, the current account deficit fell to 3.6% of GDP in 2015, down significantly from 5.2% of GDP in 2014, on the back of lower oil imports and a rise in remittances. Foreign direct investment inflows (1.7% in 2015) are among the lowest in the ‘B’ category. Net external debt rose to 29% of GDP in 2015, exceeding the ‘B’ median of 16%, primarily driven by sovereign borrowing and banking sector credit lines to support lending as deposit growth has stagnated.
Most structural indicators, such as per capita income, are somewhat stronger than those of ‘B’ category peers. The banking sector remains sound due to prudent regulation, although the weak economy could affect asset quality and profitability. Impaired loans are likely to rise, but only moderately and from a low level of 2.2% of total loans at end-March 2016.
SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)
Fitch’s proprietary SRM assigns El Salvador a score equivalent to a rating of ‘BB’ on the LT FC IDR scale.
Fitch’s sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:
– Macroeconomics: -1 notch to reflect El Salvador’s weaker potential growth prospects relative to the ‘B’ median, with important repercussions for public finances.
– Public Finances: -1 notch to reflect El Salvador’s narrow tax base and budgetary rigidities that make fiscal consolidation difficult to achieve debt stabilisation as well as the government’s increasing reliance on short-term debt to meet its substantial financing needs and the difficulty of obtaining authorization for external debt issuance given the country’s political gridlock.
Fitch’s SRM is the agency’s proprietary multiple regression rating model that employs 18 variables based on three-year centered averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch’s QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output in order to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
The Stable Outlook reflects Fitch’s assessment that upside and downside risks to the rating are currently balanced. The main factors that could, individually or collectively, lead to a negative rating action are:
–Hardening financing constraints in domestic or international markets.
–Fiscal deterioration that results in faster-than-expected worsening of public debt dynamics.
–Escalation of crime or policy mismanagement that affects macroeconomic stability and growth prospects.
The main risk factors that could, individually or collectively, trigger positive rating action are:
–Reductions in fiscal imbalances leading to the stabilisation of public debt.
–Improvements in the political and business environment that support growth and investment prospects.
–Fitch assumes that the sovereign will continue to finance itself through treasury bills and will tap the international capital markets following a political agreement that authorizes external debt issuance.
–The agency assumes that U.S. economic growth continues to support economic and external forecasts. Furthermore, that oil prices rise only gradually, helping contain imports, utility subsidies and consumer prices.
–Fitch assumes that monetary policy normalization in the U.S. proceeds in a gradual and orderly manner, resulting in no external financing constraints for El Salvador in 2016-18.
Fitch Ratings, Inc.
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New York, NY 10004
Media Relations: Elizabeth Fogerty, New York, Tel: +1 (212) 908 0526, Email: elizabeth.fogerty[a]fitchratings.com.
Additional information is available on www.fitchratings.com
Country Ceilings (pub. 20 Aug 2015)
Sovereign Rating Criteria (pub. 26 May 2016)
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