Publish in Perspectives - Wednesday, January 29, 2014
Former San Salvador mayor Norman Quijano could win El Salvador's presidential elections on February 2, spurring more investments. (Photo: City of San Salvador)
If ARENA wins in El Salvador, private investment should support faster economic growth in the near term.
BY FRANCO UCCELLI
Costa Rica and El Salvador will hold presidential elections on February 2, while Panama will elect its next president on May 4. Costa Rica and Panama are likely to elect candidates from today’s ruling parties, while El Salvador may see a return of the rightist ARENA party to power.
PANAMA: DISPUTE UNLIKELY TO DERAIL CANAL EXPANSION
Completion of the Panama Canal expansion is a foregone conclusion. The ongoing dispute between the Panama Canal Authority (ACP) and the foreign contractors working on the expansion of the waterway may delay completion of the project and cost more than initially envisioned, but it will not derail the project altogether. Claims by the contractors that construction costs have exceeded the agreed upon budget by $1.6bn and that they do not have the necessary cash flow to keep the project going have been dismissed by the ACP and the two sides are actively negotiating a resolution to the impasse. Ultimately, the matter may be submitted to arbitration, where the ACP is confident of receiving a favorable judgment. Meanwhile, work on the project has continued, though at a slower pace. Should the impasse result in the suspension of work by the contractors, the ACP has a contingency plan in place that would enable it to take over the project altogether, which is more than 70 percent completed already, and manage it until it is fully completed. Should a resolution to the impasse occur shortly, it is still conceivable that the expansion may be completed by June 2015—a date that already implies an eight-month delay from the original completion target—but that assumes that the contractors would be able to optimize their work and make up for any lost time. The bottom line is that the ACP appears to have a firm grip on the situation and is ready to take over control of the project if need be. This may potentially delay its completion and add to its cost, but, by most measures, any delay would be marginal, and any cost overruns would be manageable, perhaps in the $300-500mn range, or less than 10 percent of the project’s total budget. The good news here is that the ACP has enough financial reserves to guarantee that the project is not disrupted and that transfers to the government, which have averaged around $1bn per year, are not significantly affected.
Upcoming elections should be a credit non-event. Presidential elections are scheduled for May 4 (there is no runoff in Panama) and the inauguration of the new government for July 1. Although recent polls have consistently given a commanding lead to José Domingo Arias, of the ruling Cambio Democrático (CD) party, the main parties are all clustered around the center of the political spectrum (there is currently no viable leftist alternative in the country), so economic policy is unlikely to change regardless of who wins the election. Accordingly, not only political, but also economic stability and continuity is widely expected, making the election a credit non-event. Meanwhile, while the CD is likely to lose its majority in congress, local observers note that this is unlikely to have a material impact on the legislative process, as the CD has demonstrated skill at forging legislative alliances. Of note, the new congress is expected to sign off on a constitutional reform that would allow for non-consecutive presidential reelection after a five-year hiatus, rather than the current 10-year requirement. This would pave the way for President Ricardo Martinelli to vie for the presidency in 2019, after sitting out only one term.
Growth is likely to converge toward potential. Driven by consumption and investment (particularly construction), real GDP likely expanded between 7.5 percent and 8.0 percent in 2013, a moderation from the double-digit growth rates recorded in 2011 and 2012. Although at first sight these numbers look quite impressive, they conceal the risk that the economy may be overheating, as evidenced by elevated wage and consumer price pressures and the ongoing construction boom. Looking forward, real GDP is projected to expand by an average of just north of 6 percent over the next three years, thus converging toward estimated growth potential of 6 percent and making it more sustainable. Expected near-term growth drivers include the tourism and mining sectors, as well as infrastructure spending, post-Canal expansion, in hospitals, schools, airports, additional metro lines, and energy projects. Indeed, current estimates put the budget for infrastructure spending for the next administration (2014-19) at $19bn, up from $14bn during the current administration of President Martinelli (2009-14).
Fiscal deficit finances capex. According to official estimates, the fiscal deficit likely closed 2013 at 2.8-2.9 percent of GDP, higher than the 2.1 percent recorded in 2012, yet lower than the 3.1 percent limit imposed by the Fiscal Responsibility Law (FRL) for last year. While the FRL sets fiscal deficit ceilings of 2.7 percent of GDP for 2014 and 2.0 percent for 2015, private sector estimates put the deficits closer to 3 percent of GDP for both years, due to lower-than-expected revenue growth and Canal transfers. There are no legal consequences for violating the FRL deficit limits, only practical ones, such as potential negative rating actions, higher financing costs, etc. Recent fiscal shortfalls have been the result of aggressive government spending in infrastructure development, with capex estimated at around 9 percent of GDP per year, ranking among the highest in Latin America.
Public debt burden will continue to trend lower, but not as fast as before. Although the recent economic environment (high growth, low interest rates) has been ideal for an increase in public indebtedness, the issuance of new debt has not resulted in deterioration in Panama’s credit metrics. In fact, the opposite has been the case, with the public debt-to-GDP ratio declining from more than 60 percent in 2006 to less than 40 percent in 2013 and expected to drop to 37 percent in 2014. In an effort to diversify risk and develop the domestic capital markets, much of the recently-issued public debt has targeted local investors, despite the nearly 50bp premium that the government has had to pay to issue debt under Panamanian law. This premium is likely to narrow considerably once a Euroclearable program for local bonds kicks into full gear in April. Once the program is in place, all outstanding and future local debt would become Euroclearable. Approximately 60 percent of the government funding needs for 2014 have already been pre-financed, with the remaining 40 percent (around $600-700mn) expected to be raised locally. The local issuance plan for this year will emphasize shorter duration and any liability management transactions will focus on smoothing out the local curve.
Market strategy. Panama continues to boast very solid fundamentals and the recent noise related to the Canal expansion appears unlikely to have long-lasting negative consequences for the sovereign. As in the case of other similarly-rated Latin names, Panamanian global bonds have generally traded alongside US Treasuries, and we expect this to continue to be the case. That said, we note that trading of some of the smaller issues on the curve has also been driven by liquidity/scarcity considerations.
COSTA RICA: ELECTION UNEXPECTEDLY DOWN TO THE WIRE
Ruling party candidate is likely to win. Presidential elections are scheduled for February 2 and the inauguration of the new government for May 8. Electoral uncertainty has sharply increased in the past few months, as discontent with the government has considerably narrowed the gap between Johnny Araya, of the ruling center-right National Liberation Party (PLN), who until recently had a comfortable lead, and José María Villalta, of the leftist Broad Front Party (FA), who has benefited from the protest vote and whose call for change has resonated with young voters. With no candidate likely to secure the 40 percent + 1 of the votes needed to win the election outright, an April 6 runoff will probably be necessary to elect the country’s next president. Although the period between the first and second rounds will be polarizing and therefore quite hard for Costa Rica, most locals believe Araya will eventually win thanks to the support of the Libertarian Party, which is to the right of both leading parties and therefore more ideologically akin to the PLN. Since Araya represents policy continuity, his victory would likely be market neutral. However, should Villalta manage to capitalize on growing dissatisfaction with the current establishment and win the election, the market response will probably be negative, at least in the near term, until there is more clarity on his policy intentions, which, at present, remain rather unclear. The fear here is that Villalta would not have the support of a solid team of experienced technocrats that would stir him away from policy landmines.
Consensus on the need to fix the fiscal is there, but doing so will not be easy. There seems to be broad consensus on the need to fix the fiscal, but not on the best path to follow to reach that end. While Araya’s PLN favors a combination of revenue-enhancing and expenditure-containment measures, Villalta seems to simply favor increasing taxation on the rich. Regardless of the outcome of the election, most people believe the approach to putting the country back on stable fiscal footing will have to be piecemeal, rather than comprehensive, given the expected fragmented composition of congress. Indeed, under the current government’s proposal, which would be inherited by an Araya administration, as current Finance Minister Edgar Ayales would likely stay, a gradualist approach would lower the deficit by 3.5 percent of GDP over the next five years or so. In the process, the primary deficit, which in 2013 closed at an estimated 2.9 percent of GDP, would swing to a surplus of 0.6 percent of GDP, enough to stabilize the public debt-to-GDP ratio. Among the key elements of the PLN’s proposal are the replacement of the current 13 percent sales tax with a higher VAT (of around 14 percent) while broadening its base to include services, which are currently exempt from taxation, and the introduction of a fiscal rule. According to official estimates, last year’s government deficit totaled 5.4 percent of GDP, up from 4.4 percent in 2012, and, under a passive scenario, would print north of 5 percent this year. The details of a Villalta fiscal plan remain an enigma, though he has also stated his concern for lowering the deficit.
Timing and size of a new global bond issue is uncertain. Having secured congressional approval to issue up to $1bn in international markets during the course of this year, most people believe the government is indeed likely to place a new global bond to finance its elevated deficit, which, according to preliminary estimates, may top $3bn in 2014. What is as yet unclear, however, is the timing of such new issuance. The widespread belief is that if the ruling PLN manages to win the election on February 2 (low probability), the government would try to do the offering before the new administration is inaugurated on May 8. However, if a runoff is required (high probability), chances are the new bonds will end up being placed by the new administration, as the one-month period between the runoff and the inauguration (from April to May 8) would probably not suffice to issue a large sum abroad. In any event, the Chinchilla administration hopes to, at a minimum, start the process of issuing a new bond before leaving office. Since new governments generally have a hard time spending during their first year in power, it is not entirely clear to some people whether the full $1bn would be issued before the end of 2014. If the market is there for it, however, we believe the government would probably do it.
Colon may depreciate slightly, prompting a change in the FX regime. The colon (CRC) was remarkably stable between 2010 and 2013, deviating only marginally (1.3 percent) from its 515 CRC/USD average for the four-year period. Most observers view the CRC as overvalued and believe its real appreciation is what has kept the central bank from changing the bottom of the FX trading band (the band system has been in place for seven years). The consensus view is that the FX rate is poised to move up from its current 508 level to between 520 and 530 in the near term, paving the way for the monetary authorities to abandon the band system in favor of a managed (i.e., dirty) float regime, in which the exchange rate will fluctuate from day to day, but the central bank will attempt to influence its value by buying or selling currencies. Most people also believe the move to a managed float will probably not materialize until after the process of fiscal consolidation is well underway.
Loss of IG rating is not a widespread concern. Moody’s has had a negative outlook on Costa Rica’s Baa3 rating since September 2013. While there has been much debate within international circles about the impact that the loss of the country’s Investment Grade (IG) rating may have on the valuation of its global bonds, most locals are generally unconcerned about it. In fact, they note that while the government does watch developments on the ratings front with great interest, as rating actions may impact financing costs, they do not set ratings targets per se and are not using the possibility of a downgrade as leverage to press for support for their fiscal reform agenda. Locals believe a Moody’s downgrade is largely priced in.
Market strategy. While a victory by the ruling party in the upcoming presidential election is by no means guaranteed, with a leftist candidate emerging for the first time as a viable anti-establishment alternative, most people believe the center-right PLN party is likely to win re-election, if not in the February 2 first round, in the April 6 runoff. Such an outcome would boost government efforts to advance a gradualist reform agenda that would help to restore fiscal order over the next few years. Although given the country’s recent fiscal deterioration it may be too late to prevent the loss of its Investment Grade rating (by Moody’s), most local investors are unconcerned about the impact that a downgrade may have on bond valuations, particularly after their recent selloff.
EL SALVADOR: ELECTIONS SHAPE CREDIT PROSPECTS
Outcome of the presidential elections is binary. Presidential elections are scheduled for February 2 and the inauguration of the new government for June 1. While the latest polls suggest that Salvador Sánchez Cerén of the ruling leftist FMLN is likely to win the first-round vote, they also indicate that he is unlikely to secure the 50 percent + 1 required to win the election outright, and that a March 9 runoff would therefore be necessary. Given that the country’s third political force, the Unidad Movement of former President Tony Saca, is more ideologically aligned with the rightist ARENA, which is likely to place second in the first-round vote, most locals believe ARENA’s candidate, Norman Quijano, is poised to defeat Sánchez Cerén in the runoff. A Quijano (ARENA) victory would help to restore private-sector confidence in the government, pave the way for investments to return, and boost economic activity, at least in the near term. Alternatively, a Sánchez Cerén (FMLN) victory would probably result in a shift to the left from the prevailing center-left policy stance, though it may be only gradual at the beginning, as the FMLN may opt to show moderation ahead of the March 2015 legislative elections. Should the FMLN win the presidency this year and increase its representation in congress next, the implementation of populist, market-unfriendly policies would become a real possibility.
Political polarization/fragmentation is here to stay. By most measures, El Salvador is the most ideologically polarized country in Central America. Such polarization, whose roots can be traced back to the civil war that ended in 1992, has resulted in the fragmentation of the political system, with the right and the left aggressively competing for any and all political space available in the country. This has prompted high levels of politico-electoral uncertainty, which, not surprisingly, has raised the level of policy uncertainty and unpredictability. No significant reforms have been generally implemented during the second half of any presidential term or during the period immediately preceding a legislative election. With no sign that there could be ideological convergence anytime soon, particularly as the old guard of the leftist FMLN continues to dominate the party, El Salvador’s current electoral cycle, which will extend beyond the upcoming presidential election and last through the March 2015 legislative election, will likely prove no different. Politics will presumably continue to get in the way of sound economic policies and any much-needed fiscal reforms will probably have to wait until mid-2015.
ALBA support is critical for the FMLN. The Venezuela-sponsored Bolivarian Alliance of the Americas (ALBA) has been a key source of financial support for the leftist FMLN party. Through its unique structure, whereby a political party (FMLN) has partnered with a state-run enterprise (PDVSA) to acquire considerable assets in El Salvador under the banner of ALBA Petróleos, which is, in turn, run by an association of FMLN mayors, Venezuela’s influence—and presence—has grown exponentially. While most expect Venezuela to continue to support the FMLN for as long as it can, some fear that if Venezuela’s financial condition continues to deteriorate, it may have no choice but to interrupt its assistance to the FMLN, becoming less lenient on payments made by ALBA Petróleos to PDVSA. Worse yet, some warn that under an FMLN administration, the government may be tempted to transfer ALBA Petróleos’s debt to PetroCaribe, which is estimated to be as high as $800mn and is the result of FMLN-controlled municipalities paying only 40 percent in cash for the gasoline they purchase from PDVSA and using the remaining 60 percent to purchase the aforementioned assets, to the state, shifting the debt burden from the party to the population at large.
Low growth will remain a key policy challenge. Driven by elevated political uncertainty and relatively low private investment and consumption levels, real GDP likely expanded only 1.9 percent in 2013, matching the result for 2012 and taking cumulative growth for 2008-13 to a meager 4.3 percent. On a sectoral basis, preliminary numbers for 2013 show housing and construction lagging, and industry and commerce outperforming. The official growth forecast for 2014 is not particularly encouraging either, with real GDP expansion expected to inch up to 2.1 percent, dragged by a moderation in real investment growth to 1.5 percent from 2.8 percent in 2013. Recent studies show El Salvador’s long-term growth potential at only 2.4 percent, the lowest in Central America by a wide margin.
situation will stay weak for a while. According
to official estimates, the fiscal deficit (including pension payments) closed
2013 at 3.9 percent of GDP, significantly lower than 5.7 percent in 2009, yet
higher than 3.4 percent in 2012. The worse-than-expected result—the government
had made a commitment with the opposition to cap the deficit at 2.7 percent
last year—was largely driven by lower-than-expected revenues, which were, in
turn, explained by weak economic growth. While the budget for 2014 assumes a
3.6 percent of GDP shortfall, recent official estimates see it climbing to 4.0
percent under a passive scenario. While none of the three leading presidential
candidates has proposed clear revenue-enhancing policies, claiming instead that
higher economic growth would fix all fiscal evils in the country, most local
observers believe that, without a combination of stronger growth and fiscal
reforms, the deficit will remain dangerously high. Some of the reform proposals
being put forth include boosting the VAT rate from 13 percent currently to 15
percent (the IMF favors a steeper increase to 16 percent) and putting in place
measures to lower VAT evasion, which, despite declining 10 percent since 2006,
remains quite high, at an estimated 33 percent. Given the fragmented
composition of congress, most local observers believe that passage of an
effective fiscal reform will prove very complicated, regardless of who wins the
presidential election. Accordingly, hopes are low that any significant fiscal
consolidation will be achieved in the near term, with most people believing
that no reforms will be pursued at least until after the March 2015 legislative
Future of the gang truce is uncertain. In March 2012, El Salvador’s most violent gangs (maras), the Mara Salvatrucha and the 18th Street gang, agreed to a truce. As a result, the murder rate in the country has plummeted, but other criminal activities, such as extortion (which victimizes 70 percent of small businesses) and drug-trafficking, have not. While the FMLN government admits that it was instrumental in “facilitating”—but not “negotiating”—the truce, the future of the ceasefire remains uncertain, even if the FMLN were to win the upcoming elections. None of the leading candidates has an actionable plan to address the maras, with the FMLN’s Sánchez Cerén stating that, if elected, his administration would “review” the terms of the truce, and ARENA’s Quijano and Unidad’s Saca showing little interest in maintaining it. Indeed, ARENA and Unidad generally view the truce as a political artifice designed by the government and the maras so the former can claim victory in fostering a decline in violence and the latter can get leniency when their members are imprisoned. Against this backdrop, security (or lack thereof) considerations will remain a key challenge for the authorities.
De-dollarization is not perceived as an imminent threat. Whether to keep full dollarization in place has not been as much of a campaign issue as in previous elections. While its maintenance is not discussed at all in the context of a Quijano (ARENA) or Saca (Unidad) victory—where it is actually assumed as a given—Sánchez Cerén (FMLN) has hinted that his administration would not de-dollarize, as it would be impractical (i.e., not politically convenient) to do so. El Salvador has been fully dollarized since January 2001. The lack of any meaningful rhetoric against dollarization this time around should be welcome news for the market.
Market strategy. While our baseline scenario calls for the rightist ARENA party to win the presidential election in a March 9 runoff, thus inspiring a relief rally that should see bonds tighten by as much as 40-50bp, given the inconclusiveness of recent polls, the odds are not negligible that the leftist FMLN may surprise the market and emerge victorious. Should our baseline scenario play out as expected, increased private investment should support faster economic growth in the near term, but with legislative elections set for March 2015, the full positive impact of an ARENA victory may not materialize until after next year’s contest. Beyond that point, reforms (fiscal, in particular) will be needed to guarantee the viability of the new government’s economic plan.
Franco Uccelli is an analyst with JP Morgan Chase. This column is based on recent trip reports from Costa Rica, El Salvador and Panama. Republished with permission.