DBRS Confirms Brazil Sovereign Ratings on Good Crisis Response

DBRS has today confirmed the ratings on the long-term foreign and local currency-denominated debt of the Federative Republic of Brazil at BBB (low) and maintained Stable trends.

“The credit crisis slowed the improvement in Brazil’s creditworthiness,” says Fergus McCormick, DBRS’s Brazil analyst. “Nevertheless, given the strong policy response to the crisis, Brazil’s history of high primary surpluses, the huge scope for increased trade and investment, and investor confidence ahead of this October’s elections, it is reasonable to expect that Brazil will return to debt reduction. In fact, the realization of a more sustainable fiscal stance could result in a Positive trend.”

For the time being, creditworthiness is constrained by recent deterioration in the country’s fiscal stance and longstanding neglect of structural factors that slow the improvement of social services, affordable health and pension systems and the introduction of a less onerous tax system. While the policy response to the crisis effectively stabilized domestic demand, the government raised wages, social security payouts and quasi-fiscal development bank lending, instead of increasing public investment.

The temporary result of higher spending and the economic deceleration was a wider deficit, which increased from 1.2% of GDP in October 2008 to 3.3% of GDP by the end of 2009. Gross public debt rose from 53.1% of GDP in June 2008 to 63% in 2009. Although these increases are likely to be temporary, Brazil’s debt profile remains exposed to rollover risk and higher debt costs should lender confidence deteriorate. While much lower than in the past, one-quarter of federal debt matures within one year. Furthermore, interest payments on federal securities fully offset primary surpluses, and as the Central Bank hikes interest rates later this year, interest costs may rise.

In spite of higher debt-to-GDP, DBRS expects the government to generate a higher primary surplus of 3.3% of GDP from 2010-2012. This seems viable because as the economy recuperates tax revenues should rise, providing the government with room to meet its primary targets. The cumulative effect of rising real wages, transfers from the Bolsa Família program and better access to credit appears to have induced a larger share of the population to enter the formal economy and pay taxes.

Beyond the elections, DBRS is most concerned about the structural distortions in Brazil’s public finances. On the one hand, Brazil has set an example of the benefits of running high primary surpluses within a rules-based fiscal policy. However, Brazil has partly generated these surpluses by hiking tax rates rather than fully addressing structural fiscal weaknesses. Moreover, an uneven and complicated tax system has curtailed productivity growth and crowded out investment. A longstanding public sector pension deficit is in dire need of reform.

The crisis also served to stoke dirigiste tendencies in Brazil, as is evident by the increase in public development bank lending, a recent tax on international capital inflows and greater government involvement in the mining and energy sectors. Although the capital inflow tax does not harm creditworthiness, its effectiveness is unclear, and a better policy would be to introduce a more transparent medium-term framework to balance the budget. This would put less upward pressure on interest rates and help to stabilize the Real.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies.

This is a Sovereign rating.