DBRS Upgrades Brazil to BBB on Resilience and Growth Prospects, Trend Stable

DBRS, Inc. (DBRS) has today upgraded the ratings on the long-term foreign and local currency-denominated debt of the Federative Republic of Brazil to BBB from BBB (low), and maintained Stable trends on both ratings.

The reasons for the upgrade are: (1) a stronger economic structure from rising incomes and a burgeoning middle class, which has strengthened growth prospects, (2) better debt dynamics, and (3) proven resilience to external shocks. Together, these factors have created the conditions for an improvement in debt sustainability and placed Brazil’s creditworthiness in line with BBB rated peers. The Stable trends reflect Brazil’s credible policy framework, which has the space to provide fiscal and monetary stimulus in the event of a downturn in the global economy.

The shock to economic activity following the collapse of Lehman Brothers in October 2008, while severe, proved to be temporary. The crisis severely affected Brazil through a collapse in confidence leading to a sharp contraction in trade, investment, a credit crunch in the domestic interbank market and outflows of short-term capital. Together, these factors resulted in a deceleration of economic growth, currency depreciation and a deficit in the current and capital accounts of the balance of payments.

However, the crisis also served as a test case of Brazil’s ability to weather a severe external shock. The country rapidly rebounded from the crisis, growing by 7.5% in 2010. Stable credit conditions, buoyant real wage earnings, limited worker dismissals and healthy job creation curtailed the decline in economic activity, and a strong policy response laid the groundwork for a robust recovery. The Lula administration provided timely and forceful fiscal and monetary policy stimulus. In 2009, policy makers lowered the primary surplus to 2.1% of GDP from 3.7% of GDP in 2008. This provided space for tax cuts, housing support and social transfers. The Central Bank lowered interest rates and bank reserve requirements, providing financial institutions with breathing room to ride out the credit squeeze. Capital inflows returned and the currency stabilized.

Brazil’s resilience also derives from improved growth prospects from a stable macroeconomic environment, strengthening domestic demand and favorable terms of trade, while the size and wealth of the economy have increased. Stronger domestic demand is partly due to the Bolsa Família cash transfer program and rising real wages, which have raised average household incomes. Approximately 29.1 million Brazilians joined the middle class between 2003 and 2009, while 20.5 million escaped extreme poverty.

An increase in state bank lending and greater penetration by retail banks into poorer areas of the country have increased the formalization of the workforce, as consumers have opened checking accounts to receive state transfers, wages and pensions. Better access to credit has led to a sustained rise in private consumption and job creation. Greater formalization of a labor force tends to increase productivity, and this bodes well for a rise in potential GDP in Brazil. Huge oil and gas discoveries could transform the country into a major producer in the coming years, providing greater scope for job creation.

Resilience to external shocks is also evident in favorable terms of trade. Since the 2008-2009 credit crisis, exports and imports have rebounded while preserving a sizeable trade surplus. The external position appears to be strong, with small current account deficits and a manageable international investment position. Most important, given infrastructure needs in the growing oil and gas sector and in the run up to the 2014 World Cup and 2016 Olympic Games, high foreign direct investment inflows look set to continue. International reserves have risen from $194 billion at the end of 2008 to $352 billion on November 16, 2011, making the public sector a large net external creditor and providing the Central Bank with ammunition to smooth exchange rate fluctuations.

The upgrade also reflects better debt dynamics. Following the 2008-2009 crisis, the government increased the primary surplus target to the equivalent of 3.2% of GDP for 2011 (and 3.1% of GDP from 2012-2014). This was achieved partly by cutting expenditures and partly through higher tax receipts. The greater formalization of the workforce appears to have induced a larger share of the population to pay taxes, as automatic tax payments from a rising number of checking accounts have increased tax receipts.

A resilient economy and a stronger fiscal position have resulted in greater debt sustainability. By September 2011, gross debt, which includes bond issuances that fund state development bank loans, had reached 54.3% of GDP. Net debt had declined to 36.2% of GDP. At these levels, DBRS believes that Brazil has greater capacity to weather another external shock. Furthermore, although Brazil currently pays real interest rates of approximately 4.1% of GDP, if GDP growth estimates of 3.2% this year and 3.5% in 2012 materialize, a primary surplus of more than 3% of GDP should be sufficient to result in a steady decline in debt-to-GDP.

Despite these strengths, DBRS remains concerned about Brazil’s longstanding neglect of structural factors that could impede growth over the long term. The tax system is inefficient, curtailing productivity growth and crowding out investment, while expenditures remain highly inflexible. Furthermore, gross domestic investment is low. Nevertheless, stronger growth prospects and better debt sustainability could continue to outweigh these factors in the coming years. How Brazil weathers a potential downturn in the global economy will be an important signal for further credit improvement. If prudent fiscal policies and sustained growth lead to further improvements in debt dynamics, the ratings could be upgraded to BBB (high).

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.

The sources of information used for this rating include Ministério da Fazenda, Tesouro Nacional, Banco Central do Brasil, IBGE, Secex, BIS. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Lead Analyst: Fergus McCormick
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 6 July 2006
Most Recent Rating Update: 1 February 2010

For additional information on this rating, please refer to the linking document under Related Research.