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Why Central America's Low Sovereign Credit Ratings Are Diverging

This report does not constitute a rating action.

Low sovereign credit ratings in the region are mostly explained by long-standing structural weaknesses.   Central America's average rating of 'B' is weaker than the averages for Latin America and the Caribbean ('BB') and the world as a whole ('BBB-') (see chart 1). Since 2010, the global average rating has lost one notch (to 'BBB-' from 'BBB') while Central America has lost two notches (to 'B' from 'BB-'). Despite some exceptions, Central American sovereign credit ratings have remained constrained by fragile institutions amid weak checks and balances, low per capita income and lackluster growth, and, in some cases, moderate debt levels and limited fiscal space.

Chart 1

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However, we have recently seen diverging trends in these ratings and outlooks (see chart 2).   Over the past 12 months, we revised our outlook on Guatemala to positive (and affirmed our long-term sovereign credit rating of 'BB-') on stronger economic growth prospects, and revised our outlook on Costa Rica to stable from negative (and affirmed our 'B' rating). In contrast, we revised our outlook on Honduras to negative (and affirmed our 'BB-' rating), and we downgraded El Salvador to 'CCC+', with a negative outlook, given its increasing financial needs and limited funding sources. The 'B-' rating on Nicaragua, with a stable outlook, has remained unchanged.

Chart 2

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Central American Sovereigns Face A Variety Of Rating Constraints

Despite many cultural, social, and historical similarities within the region, credit rating assessments vary across countries (see table 1).   Costa Rica stands out as the most prosperous country in the region, with favorable social and educational indicators. It has the oldest and sturdiest democracy in the region, with a longer track record of transparent elections, institutional checks and balances, and political stability. However, our rating on Costa Rica is below that on Guatemala and Honduras, partly because of its large fiscal deficits resulting in growing government debt, and a weak track record of taking timely corrective economic policies.

The low ratings on some countries, like El Salvador and (to some extent) Honduras, reflect growing fiscal rigidities and a higher debt burden in recent years. In contrast, both Guatemala and Nicaragua have been able to stabilize their debt burden through more effective fiscal policy. Our monetary assessment for El Salvador reflects its lack of a national currency (it uses the U.S. dollar as its official currency), and our assessment of Nicaragua incorporates its limited monetary flexibility because of a high level of dollarization in its financial system (despite having its own currency). In contrast, we have a better assessment of monetary flexibility in Guatemala, Honduras, and Costa Rica, some of which have more flexible exchange-rate regimes.

Table 1

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The comparatively low sovereign ratings in the region do not reflect uniform weaknesses in all countries in all the credit factors.   Central America had once been a single country, following the dissolution of the Spanish empire in the Americas. The Federal Republic of Central America existed formally from 1821 to 1841, when it was officially dissolved. The Republic split into several countries after a civil war during 1838-1840 and was formally ended in 1841 when El Salvador proclaimed independence. Subsequently, although each of the succeeding five countries followed its own path, the region continued to have similarities in its political, social, and economic development.

However, the differences in rating factors also suggest that a common historical legacy does not necessarily result in common preordained weaknesses.   Most countries have a relatively favorable or moderate assessment in at least one credit assessment, reflecting the diversity within the region. As an illustration of regional heterogeneity, we created a hypothetical rating profile for a sovereign that is based upon the best score that we assign to any of the five sovereigns for each rating factor. Combining these scores results in an indicative rating of 'BBB-', just above investment-grade and much higher than the current regional average of 'B' (see table 1).

The following article addresses some of the region's key strengths and weaknesses that explain why we are recently seeing diverging outcomes in credit ratings and outlooks. We focus on the five countries mentioned above, and excluded other regional neighbors given key differences, such as Panama and its much higher income level and sovereign credit rating ('BBB') or Belize and its legacy of serial defaults over the past two decades.

Historically Weak Institutions Amid Fluid Political Dynamics

Long-standing institutional fragilities have constrained sovereign credit ratings.   Central America's history of authoritarian and military regimes, and a late start in democracy (except for Costa Rica), translate today into still-weak (yet evolving) public institutions, fragile checks and balances, high levels of perceived corruption, and inadequate access and quality of public services, among other hardships. Furthermore, being located in the transit route between drug-producing countries in South America and consuming markets in the U.S. and Canada has given way to the development of criminal organizations and drug-related violence across the region.

Despite these commonalities, there have been stark institutional differences among these countries, and recent elections are reshaping the political environment within the region.   Over the past three years, there were changes in ruling political parties in almost all countries (except Nicaragua). Following these changes, the governments of Honduras and El Salvador have increased their commitment to social spending, while Guatemala and Nicaragua have done so more timidly, also prioritizing their macroeconomic stability, either because of prudent financial policies or limited options to finance these policies.

In contrast, Costa Rica has been able to build more mature and democratic institutions, although political fragmentation has often delayed important reforms over the past years, contributing to downgrades. Governments in the region are facing the challenge of taming the spike in inflation amid a tougher international context while attending to the long-term scars from the COVID-19 pandemic shock. The ability to successfully appease these social demands will likely frame the next presidential elections in all five countries, which are scheduled between 2023 and 2026.

Lackluster Economic Growth Is Still A Challenge

Despite the post-pandemic economic rebound, low potential growth remains a key rating constraint.   Central America had a strong recovery in 2021, fueled by external demand and strong remittances performance that supported household consumption. The severe pandemic shock exacerbated the preexisting economic weaknesses, although with a differentiated impact among countries (see chart 3). Guatemala has had the strongest economic performance and not only achieved its pre-pandemic GDP level early in 2021, but is also expected to surpass its prior trend growth. We forecast Honduras and Costa Rica to resume their long-term trend growth rate within the next two to four years. El Salvador would follow suit although at a slower rate, given that economic growth has been weaker over the past decade. By 2025, Guatemala's GDP will have grown by 70% with respect to 2010, while El Salvador's will do so by 40%. Nicaragua has been hit by successive external and domestic shocks since 2018 and, despite higher growth in recent years, the economic impact will be more permanent than cyclical.

Chart 3

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We expect economic growth to remain low over the medium term, although there are important upside and downside risks to the economic growth trajectory.   On the one hand, the linkages to the U.S. and nearshoring trends could provide a boost to economic growth in Central America. So far, this trend has been mostly a Mexican phenomenon and, despite private-sector investment announcements, the region still needs to lay the ground for these initiatives to be fully exploited. On the other hand, growth expectations in the region will continue to be linked to U.S. economic performance, given that the U.S. is the main destination of exports and the main origin of remittances. The rising risk of a sharper-than-expected slowdown in the U.S. economy as the Fed rapidly tightens policy to bring down inflation is a risk to growth in Central America (see "What A Hard Landing For The U.S. Economy Would Mean For Emerging Markets," Aug. 3, 2022).

Having said that, growth is unlikely to translate into a substantial improvement in social development.   Regional per capita GDP has remained relatively stagnant over the past decade (see chart 4), reflecting structural weaknesses from the high level of informality, many years of low investment, sociopolitical tensions, and weak competitiveness in most countries.

Chart 4

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External Vulnerabilities Differ Across Central America

Despite the severe pandemic shock, risks have been partially mitigated by high global liquidity and record-high remittances.  During 2020-2021, a steep decrease in imports as a result of the economic contraction and remittances inflows worked as a significant external buffer. The latter are explained by a strong recovery in employment among Central American immigrants in the U.S. and the substantial fiscal stimulus that boosted their disposable income. We expect remittances to continue growing significantly in 2022 but to gradually normalize as a share of GDP over the coming years, though still with a key role in most of these countries' external profiles. For example, in El Salvador and Honduras, remittances inflows accounted for as much as a quarter of its GDP in 2021.

Chart 5

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However, we project current account deficits (CADs) to slightly worsen in coming years as a result of higher imports from the economic recovery and normalization of remittances.   Despite little direct exposure to Russia and Ukraine, we expect Central America to suffer from indirect consequences from higher commodity prices as the region is partly dependent on oil imports to meet energy demands. This will be partly compensated by an increase in exports, mainly from free-trade zones, which have had a substantial increase in many of these countries over the past two years. As a result, we expect current account balances to worsen and turn to deficits of around 2.5% of GDP, on average, over the next three years, following two extraordinary years of current account surpluses.

Chart 6

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We expect foreign direct investments (FDI) will remain subdued and CADs to be financed largely through public- and private-sector external borrowings.   Economic weaknesses and low competitiveness should keep international investment in the region low. We forecast FDI to average around 2% of GDP over the next three years. Among these countries, Guatemala stands out as having somewhat a stronger external profile, given that it has lower external debt and high international reserves, it is the only country that has consistently posted current account surpluses, and it is a more closed economy than the Central American average (Guatemala's exports account for 18% of GDP, whereas the rest of the countries hover around 30%-45%). Furthermore, Guatemala had an uptick in FDI inflows following the international acquisition of a telecommunication company in 2021.

At the same time, the excess liquidity in the market throughout the pandemic allowed governments to finance their support packages through external and domestic borrowings.   Most of these countries received budgetary support from official creditors, and some tapped international markets in the midst of the pandemic, which helped boost international reserves and maintain comfortable external liquidity ratios. In a global context of higher interest rates and weak sovereign bond market performance for some countries, we consider that it might be more difficult to access the global capital markets at reasonable rates. As a result, some of them could resort to financing from official creditors, such as the IMF, which could also help anchor expectations regarding future fiscal trajectories. Having said that, Guatemala has recently issued an international bond for US$500 million, due in 2029 and with a coupon of 5.25%.

Fiscal Packages Helped Mitigate The Pandemic Impact …

Central American countries will continue to face fiscal pressures given the complex global situation, especially those that have depleted the limited fiscal space during the pandemic shock.   Most governments in the region are responding to rising inflation and higher commodity prices by granting subsidies and tax exemptions. Although these measures might cushion the impact on domestic consumption, they come after the deployment of sizable fiscal packages to attend to the most vulnerable households and support businesses throughout the pandemic. Hence, the fiscal space has become narrower. As economic growth rebounded after the pandemic, revenue collection strengthened in most of these countries, although spending pressures have remained, especially stemming from the increase in commodity prices internationally due to the region's dependence on hydrocarbon imports, and subsequent higher inflation.

We expect governments to gradually reduce fiscal deficits in coming years, although the speed of the consolidation will differ and mostly depend on the availability of funds to finance the transition (see chart 7).   El Salvador and Honduras implemented a larger fiscal stimulus package during the pandemic, and we expect their fiscal correction process will be more difficult. Their change in debt increased from 3% before the pandemic to 7%-9% in 2020-2021. Furthermore, Honduras aims to slowly reduce the deficit by 0.5% of GDP over the next eight years. On the other hand, Costa Rica and Nicaragua, starting from a weaker fiscal standpoint before the pandemic shock, had a more muted increase in fiscal deficits during the pandemic. We expect a somewhat faster fiscal consolidation in Nicaragua given the limited access to financing sources, while Costa Rica's dynamics will likely hinge on the government's capacity to execute fiscal adjustment given bureaucratic hurdles and political fragmentation. Guatemala stands out as being the country with the lowest fiscal deficit, and we expect it to increase over the coming years as part of the country's strategy to boost economic growth through public investment.

Chart 7

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A key constraint for the region is its very low capital investment and poor infrastructure.   We assess there are important infrastructure needs in almost all of these countries, which will continue to weigh on their fiscal performance. Excluding Costa Rica, which has better infrastructure, these countries rank poorly in the Human Development Index, around 124-132 out of the 189 countries analyzed. Given that governments will be focusing on gradually reducing their fiscal deficits, we expect public spending in infrastructure to remain low. In particular, low capital expenditure in Central America mirrors the low levels of Latin America as a whole and is a key factor explaining lower economic growth vis-à-vis other regions worldwide.

… But Led To Higher Debt Levels

A long-term consequence of the pandemic is higher debt, which will limit the fiscal space ahead of future external shocks.   Mirroring the spike in fiscal deficits, there has been a substantial increase in net general government debt across the region. This will remain a key vulnerability, especially taking into account that these sovereigns are exposed to external shocks, such as a deceleration of the U.S. economy, higher inflation, interest rate hikes globally, and potential natural disasters. We expect debt levels to stabilize at the post-pandemic level, with El Salvador and Costa Rica being the most indebted as a percentage of GDP. Honduras and Nicaragua's debt levels will hover around 50% of GDP, while Guatemala will keep a very prudent fiscal approach and debt levels of around 20% of GDP, among the lowest in Latin America.

Chart 8

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Apart from higher debt, there are meaningful risks stemming from these countries' debt profile.  For example, a large share of the debt of these countries is denominated in foreign currency and subject to exchange-rate risk. This accounts for around 60% in Honduras, and 40% in Guatemala and Costa Rica. On the other hand, as debt levels spiked, the interest burden has been taking up an increasing share of the government resources, limiting its fiscal flexibility. This is particularly relevant given the exchange-rate risk that could push interest payments even further, and the expectation of real interest rate hikes globally. Costa Rica and El Salvador have the highest share of interest payments as a percentage of the government revenues, at around 18%. In contrast, Nicaragua's lack of commercial debt allows it to devote less resources to pay its concessional debt to official creditors.

Chart 9

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Myriad exchange-rate regimes grant different monetary policy flexibility to each country.  Central America has a wide variety of exchange-rate arrangements, ranging from more rigid dollarization in El Salvador or a crawling peg in Nicaragua and Honduras, to more flexible, managed, and floating regimes in Guatemala and Costa Rica. As a result, some countries will have more tools to tame the global increase in inflation, while others will remain more vulnerable to international dynamics. Despite El Salvador approving legislation to make bitcoin an alternative legal tender (together with the U.S. dollar since 2001), the adoption so far has been low, and we do not expect major changes to the country's exchange-rate regime.

Structural factors, although very relevant, do not predetermine these countries' fate.   We expect all five Central American countries will face challenging external conditions and various domestic risks in the coming years--for example, U.S. economic deceleration, hikes in global interest rates, and higher inflation. However, each of these sovereigns will face these risks from a different financial position. As evidenced by the currently diverging ratings and outlooks, it will depend on each country's own policies to determine its rating trajectory. Having said that, given the deep-rooted institutional and economic weaknesses, it would take a long time for these countries to achieve materially higher sovereign credit ratings, if it ever happens.

Related Research

Primary Credit Analysts:Patricio E Vimberg, Mexico City + 52 55 1037 5288;
patricio.vimberg@spglobal.com
Omar A De la Torre Ponce De Leon, Mexico City + 52 55 5081 2870;
omar.delatorre@spglobal.com
Lisa M Schineller, PhD, New York + 1 (212) 438 7352;
lisa.schineller@spglobal.com
Secondary Contacts:Joydeep Mukherji, New York + 1 (212) 438 7351;
joydeep.mukherji@spglobal.com
Constanza maria Chamas, Mexico City +52 5510375256;
c.chamas@spglobal.com

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