DBRS Upgrades Brazil’s Local Currency Rating to BBB (high)

DBRS, Inc. (DBRS) has confirmed the long-term foreign currency issuer rating of the Federative Republic of Brazil at BBB and the short-term foreign currency issuer rating at R-2 (high). DBRS has also upgraded the long-term local currency issuer rating to BBB (high) from BBB, and the short-term local currency issuer rating to R-1 (low) from R-2 (high). All four ratings have Stable trends.

The upgrade of the local currency ratings reflects a steady decline in net public debt to GDP and improvements in the public debt profile. The ongoing development of Brazil’s local capital markets has contributed to improvements in the government bond market. Net public debt, composed of tradable securities and central bank repo operations, declined to 35.7% of GDP in February 2013. Other improvements are evident in the lengthening of the local currency yield curve, in greater diversification of the investor base, and in a more favorable composition. Non-residents own 13.4% of Brazil’s bonds. The share of fixed rate debt has risen to 38.8% from 36.6% in 2010, inflation-linked debt has increased to 33.9% from 26.6%, while floating rate debt has declined to 22.8% from 31.6%. The average maturity of the debt has gradually increased to 4.1 years, of which the average maturity of external debt was 6.6 years.

The broadening of the local capital markets has provided the private sector with means of financing and vehicles for saving and investment outside of the government bond market. Recent years have seen rapid growth in mutual funds, equity market capitalization and corporate bond issuance. The growing sophistication of local capital markets provides the public sector with a wider investor base, and therefore greater flexibility to generate financing in local markets.

The decline in net public debt is due to Brazil’s consistently high primary surplus, which averaged 2.6% since 2002, as well as moderate growth rates. Lower debt and prudent macroeconomic policies have helped create the conditions for a larger and wealthier economy. At $2.3 trillion, Brazil is now the world’s seventh largest economy, and its middle class is estimated to have grown by 36 million between 2002 and 2012. In U.S. dollars, GDP per capita is now $11,617. In Reais, GDP per capita has increased 27.5% since 2002. A larger domestic economy and higher incomes have led to more diversified and stronger private consumption.

Contributing to macroeconomic stability is Brazil’s resilient external sector. External debt is low at 13.9% of GDP. A flexible exchange rate has served to buffer external shocks. The 2008-2009 global financial crisis tested Brazil’s ability to weather a severe external shock. A rapid accumulation of international reserves, currently at $378 billion, has increased external liquidity. A manageable current account deficit of 2.4% of GDP, driven by profit and dividend remittances from investments by non-residents, is fully financed by foreign direct investment inflows.

Notwithstanding this external strength, a recent moderation in global commodity prices has resulted in lower export receipts. Nevertheless, oil and gas discoveries have the potential to gradually increase Brazil’s energy exports over the coming years, and this should lead to a lower current account deficit. 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 FDI inflows look set to continue.

These strengths are offset by structural constraints that prevent Brazil from reaching higher rating levels. Moderate growth in 2011 and 2012 of 2.7% and 0.9%, respectively, has highlighted the need to increase productivity to promote faster, less volatile and more evenly distributed growth. In the years leading up to the crisis, growth was driven by the commodities boom, an increase in credit, productivity gains and an expanding labor force. However since 2010, commodities prices have declined, job creation has slowed and the Central Bank has raised capital requirements, and this has slowed the growth of credit.

Contributing to lower growth are supply side and structural constraints which include a low savings rate that has averaged 16.5% of GDP since 2000. This is close to 15.7% of GDP in Turkey, but well below 25.5% in Mexico, 29.4% in Russia, 30.2% in India and 47.4% in China. Even with the development of local capital markets, this level of saving is insufficient to support a higher rate of investment without generating larger external imbalances.

Low saving puts upward pressure on interest rates which further impedes growth. Despite a significant reduction in interest rates in recent years – most recently a 525 basis point monetary easing cycle – most Real-denominated contracts are indexed to the overnight interest rate. This lowers market liquidity risk, but increases debt service costs for borrowers and interrupts monetary transmission. Such market concentration is further perpetuated by directed credit from Brazil’s public banks. This credit at below market rates helps borrowers in housing, agriculture, selected industries, energy and SMEs, but discourages long term investment, competition and intermediation.

The rapid expansion of credit over the last decade helped to fuel economic growth and the broadening of financial markets. However, the speed and duration of the growth in credit, especially to households, and the rapid rise in housing prices in prime locations, is a concern. However, these risks are mitigated by the low level of credit, at 53.8% of GDP, and a recent moderation in credit growth. Furthermore, the banking system is highly profitable, capital and liquidity buffers are high, banks have low exposure to cross-border funding or foreign exchange risk, and bank supervision and regulation have been strengthened.

Another supply side constraint to growth is the business environment. Improving the business environment would go a long way toward raising economic efficiency. Currently, high production costs, administrative barriers and rigid labor laws stymie a more efficient allocation of labor and capital. Greater investment in transport infrastructure and the energy sector would improve competitiveness for Brazilian companies by raising productivity and reducing structural impediments such as high energy input costs.

Longstanding structural factors further impede growth. These include a distortionary tax system, poorly targeted primary expenditures, a low quality of education, an indexed private pension system with low retirement age requirements, and an inequitable public pension system, which as the population ages will lower public savings even further.

The Rousseff administration has taken action to reform the public pension system by introducing a defined contribution pillar for public sector workers, which caps benefits for new government employees and limits their contributions. This should encourage savings over the medium term. Further parametric reforms to the pay-as-you-go pension system and greater competition among savings accounts could help to increase savings rates and investment. A reform of the ICMS value added tax system to align the rates of the 26 federal states, scrap double taxation on goods, and create a federal compensation fund to ease the transition, are being considered. However, prospects for passage of this legislation are unclear.

The administration has also taken steps to promote industrial activity. Public banks have provided low interest loans and the government has selectively raised import tariffs, imposed capital controls, extended subsidies and intervened in the foreign exchange rate market. A strong currency appears to be partly responsible for a multi-year decline in industrial output. However, it is unclear whether, in the absence of higher investment and a more efficient allocation of capital, these measures will improve Brazilian competitiveness.

The ratings are likely to remain at current levels until these constraints to growth are addressed more comprehensively. If higher growth rates and lower debt ratios materialize, this could result in further ratings upgrades. Alternatively, structural deterioration in the fiscal stance that puts the public sector debt trajectory on an upward path could result in Negative trends.

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

The principal applicable methodology is Rating Sovereign Governments, which can be found on our website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales.

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

This rating is endorsed by DBRS Ratings Limited for use in the European Union.