El Salvador’s $800 million sovereign bond will be due in January 2023, and there are many speculations right now about their default probability. International financial markets believe the Central American country will stop scheduled repayments in eight months, just over a year after adopting bitcoin as legal tender.
El Salvador has stubbornly low economic growth, a large fiscal deficit, and government debt equal to nearly 90% of GDP (costing 5%per year compared with 1.5% in the U.S.).
Without significant changes in economic policy, the country faces a dangerous sovereign default.
Most practitioners and academics agree that sovereign default has significant consequences. This is especially true in dollarised countries like El Salvador, where missed government payments could spark a bank run. As in other emerging economies, El Salvador’s local banks, insurance firms, and pension funds have a lot of domestic government debt and some foreign government debt on their balance sheets.
Even if President Nayib Bukele‘s government only defaulted on the country’s foreign debt, the domestic debt would become riskier (and less valuable), resulting in mark-to-market paper losses across both types of bonds, which would erode bank equity cushions and harm the financial system’s balance sheets.
In this scenario, a large minority of Salvadorans may prefer to keep their money in physical cash or safe U.S. banks rather than riskier domestic banks. Large cash withdrawals or outflows to the United States could put a strain on domestic bank liquidity and push weaker banks into insolvency. El Salvador’s monetary authority cannot print US dollars to calm a panic or rescue failing institutions (only the US Federal Reserve can), so the central bank would have to manage the stress with its limited reserves worth $3.4 billion – or 12% of the country’s GDP.
Given the risks and costs of a sovereign default, it is understandable that El Salvador wishes to continue paying. For the time being, the government appears eager to continue servicing the debt. El Salvador Finance Minister Alejandro Zelaya insisted in March that the country’s default risk was “zero” and that the government was committed to paying in all scenarios.
For one, Bukele is looking to get re-elected in two years, in June 2024, and govern for another five years after that. His approval ratings are extremely high (85%), and his grip on the media and the legal system is tightening, virtually ensuring victory in the polls.