DBRS Confirms Brazil at BBB, Stable trend

DBRS, Inc. has today confirmed the Federative Republic of Brazil’s long-term foreign and local currency issuer ratings at BBB and BBB (high), respectively, with a Stable trend. DBRS has also confirmed the short-term foreign and local currency issuer ratings at R-2 (high) and R-1 (low), respectively, with a Stable trend.

The Stable trend reflects Brazil’s resilience to external shocks and good medium-term economic prospects, given the likelihood of tighter fiscal policy and greater momentum on the reform agenda. Widespread popular demonstrations calling for better social services and infrastructure occurred in 2013, and elections this October are likely to result in a government with a mandate to address structural impediments to growth. In the near term, policy flexibility has diminished as accommodative fiscal policy has led to larger fiscal imbalances and rising gross debt-to-GDP, and inflation has remained above the central bank target. In a context of normalizing U.S. monetary policy, Brazil is well positioned to weather external shocks, but limited progress on supply side reforms points to a weak growth outlook in the near term.

The ratings could come under upward pressure if a tighter fiscal policy places gross debt to GDP on a firm downward path, and is accompanied by progress in addressing underlying sources of low productivity. The ratings could come under downward pressure if debt ratios rise, or there is a sustained deterioration in the fiscal stance.

The ratings are supported by Brazil’s large, diverse, resource rich economy. At 3% of world GDP, Brazil is the world’s seventh largest economy. It benefits from substantial natural resources in energy, agriculture, metals and other sectors, while a large internal market allows for specialization, diversification and economies of scale. Over the last decade, Brazil has broadened the economic base by creating more inclusive growth. Government cash transfers reduced poverty, lowered income inequality, increased access to primary education and raised incentives for investment in education and worker training programs. Real growth in wages and pensions increased household incomes. These factors contributed to an expansion of the lower middle class, which is estimated to have grown by 49 million people since 2003.

Brazil weathered the 2008-2009 global financial crisis and two bouts of international turbulence in 2013 due to its strong external balance sheet. Public and private external debt is low at 14.6% of GDP, while international reserves are high at $380 billion, almost 17% of GDP. As a result, Brazil is a net external creditor. A flexible exchange rate has served as a buffer to external shocks. Healthy net foreign direct investment inflows finance three-fifths of the current account deficit. Oil and gas discoveries have the potential to convert Brazil into a major energy exporter.

A solid framework for bank regulation and supervision reinforces financial stability and a stable banking system. The banking system is highly profitable, capital and liquidity buffers are high, non-performing loans are low, and banks have low exposure to cross-border funding and foreign exchange risk. Although annual credit to the real estate market increased by 30.9% in May, the mortgage market is small and therefore poses low systemic risk. Credit to households and non-financial corporations as a percentage of GDP has been relatively stagnant, likely reflecting low demand for credit.

The largest challenge Brazil faces is slow growth. Until the international financial crisis, high growth rates were driven by a consumption boom and favorable terms of trade; since 2011, low growth has highlighted the need to raise productivity. Low productivity is a result of poor infrastructure, a burdensome tax and regulatory environment, wage indexation and other rigidities in the labor market, and a poor quality of education. A low domestic savings rate is a contributing factor to low GDP growth. Low saving, especially among households and the public sector, is insufficient to support a higher rate of investment without excessive reliance on foreign funding. Parametric reforms to the pay-as-you-go pension system and greater competition among savings accounts could help to mobilize savings and increase investment. Rising incomes and greater financial inclusiveness could further help to raise savings and investment.

A rigid fiscal structure poses another challenge. An inefficient and unfunded pension system, an uneven and burdensome tax system, and high mandatory expenditures and earmarked revenues weaken Brazil’s public finances. Expenditures are further constrained by chronically high interest payments, requiring high primary surpluses, creating structural deficits and limiting spending flexibility. Addressing these rigidities would help to lower the debt burden and allocate spending toward more productive sectors of the economy. Exchange rate shocks, combined with Brazil’s structural deficiencies and demand side constraints have contributed to long-standing price pressures. Despite low growth and high nominal policy interest rates, the IPCA consumer price index chronically posts annual inflation above the central bank’s 4.5% target.

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

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

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance. Information regarding DBRS ratings, including definitions, policies and methodologies are available on www.dbrs.com

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

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

Lead Analyst: Fergus McCormick
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 6 July 2006
Most Recent Rating Update: 29 April 2013