Will El Salvador default on its debt because of Bitcoin? Markets say yes
The price of insurance against El Salvador defaulting on its loans for five years has now tripled since the country adopted Bitcoin as legal tender last year.
Rising cost of default insurance shows investors are concerned that strained diplomatic relations between El Salvador, the US, and the International Monetary Fund (IMF) could delay president Nayib Bukele’s lofty economic goals.
The surge also comes after Moody’s downgraded El Salvador’s credit rating in July last year, from B3 (“speculative and a high credit risk”) to Caa2 (“poor quality and very high credit risk“).
Moody’s bumped it down partly in response to Bukele’s Bitcoin law — which had been passed at the time but was yet to be fully implemented.
Credit default swaps bet on El Salvador collapse
In the 1990s, Bankers Trust and JPMorgan introduced the credit default swap. These contracts compensate buyers if another entity can’t pay their debts and subsequently defaults.
Credit default swaps are also known as “default insurance,” as the owner pays a premium to purchase the swap and receives a large payout on the rare occasion that a specified entity does not repay their debt.
- Purchasing a credit default swap is effectively equivalent to gambling on whether an entity won’t be able to cover their debts.
- If you’re right, you receive a healthy profit.
- Insurance companies and banks typically issue credit default swaps and will buy the debt at face value if the owing party defaults.
As credit default swaps gained popularity, contacts tied to the loans of thousands of distinct companies began to circulate. Credit default swaps were soon written to cover private companies and even sovereigns.
Standardized contracts gained listings on reputable exchanges and liquidity increased. The likelihood of default for sovereign debt issuances quickly became quite easy to quantify.
Today, it’s possible to measure the likelihood of bankruptcy for El Salvador’s government via the deep liquidity of global credit default swap markets.
El Salvador’s credit default swaps are looking worse by the day. Investors piling into bet that El Salvador will default sometime in the next five years have pushed contract prices up more than 360% since early September, from just over $400 to nearly $1,900.
Creditors say ‘money please’
In any case, strained diplomatic relations also complicate Bukele’s plans. The White House renewed some sanctions against El Salvador last month, alleging lack of transparency and corruption.
The US holds considerable sway over the IMF, which remains El Salvador’s largest creditor.
The IMF notably issued a stark warning against backing El Salvador’s plan to adopt Bitcoin, stating it “gives rise to fiscal contingent liabilities” in its November report.
- According to the IMF, El Salvador’s gross debt grew to 89% of its GDP in 2020.
- The IMF projects that the nation’s gross debt will grow to 98.6% of its GDP within five years.
- The IMF sees no slowing in the rate of growth for El Salvador’s debt-to-GDP.
Markets for Salvadoran sovereign bonds also reflect substantial uncertainty that El Salvador will repay all of its debts. Rating agency Fitch reported the government maintained $2.6 billion in short-term debt leading into 2022.
Sovereign bonds coming due in 2023 last traded at just $0.80 on the dollar. Investors are also unimpressed with Bukele’s plan to issue $1 billion in tokenized debt. They would prefer that El Salvador mend its relationship with the IMF.
Due to its fiscal deficit, Fitch in October calculated that El Salvador’s “financing gap” for this year’s budget at $1 billion, and noted that Bukele’s government would need to roll over its short-term debt to make ends meet this year.
Fitch said it assumes El Salvador can do just that to avoid default, but the “capacity of El Salvador’s banks to increase government funding is unclear and external market rates are high.”
“Closing the large financing gap and rolling over the large stock of short-term debt will therefore prove challenging absent an IMF program and the associated multilateral funding it would unlock.”
Bukele turns to raising Tether instead
But Bukele and the IMF’s relationship is on the rocks. Fitch cited Bitcoin, dissolution of an anti-corruption watchdog, removal of members of El Salvador’s constitutional court and its attorney general as “complications” to potential IMF debt program this year.
Instead, Bukele has committed to exotic debt offerings on Blockstream’s Liquid network, backed by Tether (USDT) and Bitcoin (BTC), with inexperienced Bitfinex executives as its bookrunners and legal consultants.
Bukele also plans to use half of the proceeds from that $1 billion-bond sale to buy Bitcoin — another risky investment decision driving up the cost of Salvadoran credit default swaps.
El Salvador currently holds at least 1,391 BTC ($59.1 million). Despite Bukele’s gloating about buying in for $54,000 apiece on Twitter, his indiscretion has obviously lost money to date due to Bitcoin’s price decline.
Bloomberg more recently calculated Bukele had lost around $10 million by practically buying the Bitcoin top with public money, down 14% overall as of the second week of January.
Bukele previously claimed to be building pet hospitals and schools with profits generated by his Bitcoin-investing fund. However, it’s clear that Bukele hasn’t actually sold any Bitcoin to utilize those “profits.”
Read more: [Read this before criticizing El Salvador’s adoption of Bitcoin as legal tender]
Bukele’s Bitcoin Fund also manages a pool of US dollars; the government calculated how much the fund was ahead late last year (a “surplus”), and skimmed an equivalent amount of fiat to pay for the pet hospitals and schools.
So, in reality, the Salvadoran fund is down on its Bitcoin investment and it blew a bunch of unrealized “profits” on doggy day care new infrastructure that’ve now evaporated off the page.
Maybe the credit default swap markets are onto something.
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