El Salvador became internet famous about a year ago first when President Bukele declared that they would be the world’s first country with Bitcoin as a legal tender and second when their president began having his government buy Bitcoin as a “sovereign wealth fund.”  But flirtations with the Bitcoin ponzi are not even El Salvador’s biggest problem.  El Salvador owes billions of dollars in sovereign debt, and due to a large government deficit and little hope of improving economic conditions, the debt is currently at junk status.  The status of debt is basically how people express the risk of the debt not being paid back in full, and for El Salvador that risk is very high.  The money markets that have lent money to El Salvador believe it to be somewhat likely that El Salvador will default on its debt, leaving them with either nothing or less than the full amount that they lent, and because of that the debt is considered to be junk status.

What is a default?  A default is basically where a country declares it won’t pay back its debt.  It may be a partial default (we won’t pay back specific bonds) or a “haircut” (we’ll pay back only a certain percentage of what we owe) or a total default (we won’t pay back anything).  But a default leaves the lenders with less than the face value of the debt they lent to the country, and it in turn makes other lenders way less likely to lend money to that country.  Think about it, if you lend a buddy 100$ and he never pays you back, will you lend him another 100$ next time?

Now even junk debt isn’t worthless.  It may be *likely* that El Salvador defaults but it is not *certain*.  So if you hold an IOU from El Salvador, you can still try to make money off of it.  Let’s say you own El Salvador government debt worth 100$.  You think it unlikely that you’ll get back the full 100$ but someone else will buy the debt from you for 20$.  You’re taking a loss by selling the debt instead of waiting for El Salvador to pay up, but the 20$ they will give you is more than the 0$ you think El Salvador will give you, so you go ahead and sell it.  This sort of debt market happens all the time as institutions sell and buy debt based on their expectations of how likely the debt is to be paid back.  As economic conditions improve, the likelihood of being paid back increases and the price of the debt can rise, while worsening economic conditions would make it fall.

The problem is that President Bukele saw this debt market, and he hatched a scheme.  The debt markets think that El Salvador is unlikely to pay back its debt, and so 100$ of debt can be bought for 20$.  Well, thought the president, what if El Salvador just buys back the debt itself?  Now we can wipe away 100$ of debt for just 20$, genius!  Except not really, the debt is trading cheaply on the expectation that it won’t be paid back in full.  Buying it at this discount is an admittance that El Salvador won’t pay it back in full, they won’t pay back 100$ for 100$ worth of debt, they’ll pay back 20$.  In some ways that is a de facto default, and in the future when El Salvador wants to take out a loan (and remember they need loans to cover their deficit), banks will be very leery of giving a loan to a country that basically entered a partial default.  Secondly, President Bukele announced this scheme on twitter, and with this public announcement the price of El Salvador’s debt went way way up.  Obviously a lot of people holding El Salvador’s debt expected to get nothing, so with the public announcement of a buyback they now expect to get something and will raise their prices accordingly.  If the president thought he could buy back all the debt on the cheap, he’s very likely to be mistaken.

I don’t know who advises the president of El Salvador, but it seems like he does financial policy without much understanding of the effects.  By the way, this entire article is written using dollar denomination because El Salvador’s debt is denominated in dollars and dollars are an official currency (alongside Bitcoin). It’s probably one of the reasons El Salvador doesn’t have many economic levers to pull, they don’t control their own money supply.