DBRS Downgrades Brazil to BBB (low) Stable

DBRS, Inc. has today downgraded the Federative Republic of Brazil’s long-term foreign currency issuer rating to BBB (low) from BBB, the long-term local currency issuer rating to BBB from BBB (high), the short-term foreign currency issuer rating to R-2 (middle) from R-2 (high), and the short-term local currency issuer rating to R-2 (high) from R-1 (low). All of the ratings have a Stable trend.

The downgrade reflects a sharp deterioration in public finances. Together with higher interest rates and an economic downturn that DBRS believes to be about -2.0% this year, this has caused a broad-based deterioration in sovereign credit quality and a worsening of debt dynamics. Weaker growth was initially caused by the end of the commodities super-cycle and the end of a period of high domestic credit growth. A series of price controls and fiscal stimulus during President Dilma Rousseff’s first term deepened the downturn. The investigation of Petrobras executives accused of collaborating with contractors to bribe politicians, has further affected confidence and growth. The introduction of tighter fiscal and monetary policies further exacerbated the downturn. A downward revision of fiscal targets on July 22, primarily as a result of lower revenues, suggests that in the near term primary fiscal balances will remain below levels consistent with a stabilization of public debt dynamics.

The Stable trend reflects a shift from demand side policies to more orthodox policies to correct built-up imbalances. This is apparent in the fiscal adjustment measures recently introduced: tax hikes, cuts to labor benefits, stricter rules for pension payouts, liberalization of administered prices, and tighter lending conditions for public banks. The Central Bank has complemented these initiatives by tightening monetary policy. In DBRS’ view there is a reasonable chance that the adjustment will materialize in higher primary surpluses and lower inflation, providing space for a return to growth and a stabilization of debt ratios over the medium term.

The ratings could come under downward pressure if the commitment to fiscal consolidation materially weakens. On the other hand, the ratings could come under upward pressure if a tighter fiscal policy places debt ratios on a firm downward path, especially if accompanied by progress in addressing underlying sources of low productivity. The areas of our analysis that are mainly responsible for the downgrade are the Political Environment, Fiscal Management and Policy, Debt and Liquidity, and Economic Structure and Performance sections.

The ratings face several challenges. The first is that while the widening Petrobras investigation is a testament to the strength of Brazilian democratic institutions, as the Petrobras investigations spread to more company executives and members of Congress, there is a risk of political gridlock that delays fiscal and reform legislation.

A second challenge is Brazil’s rigid fiscal structure, which suffers from high deficits, distortionary taxation and misallocated spending. This is especially evident in an inefficient and unfunded pension system, an uneven and burdensome tax system, and high mandatory expenditures and earmarked revenues. Expenditures are constrained by chronic 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.

High inflation is also a challenge. Despite low growth and a hiking of the Selic policy interest rate to 14.25% in July, inflation has reached 9.25% - well above the Central Bank’s 4.5% target. This was mainly a result of hikes in regulated prices, which had been repressed.

A fourth challenge is the low growth outlook. High production costs and supply side bottlenecks impair the economy’s ability to grow. Brazil’s poor productivity performance is the result of inadequate infrastructure, a burdensome tax and regulatory environment, wage indexation and other rigidities in the labor market, and low quality education. A low domestic savings rate is also a contributing factor, especially among households and the public sector, and savings is insufficient to support a higher rate of investment without excessive reliance on foreign funding.

Several strengths offset these challenges. The ratings are supported by the Rousseff administration’s recent reversion to market-based policies. Following the escalation of the Petrobras investigation, President Rousseff shifted her economic policy from a statist model to a more market-based one, with fiscal consolidation as the main pillar. The appointments of Joaquim Levy as Finance Minister and Vice President Michel Temer of the PMDB as responsible for political relations with Congress, have been instrumental in gaining legislative approval of most of the adjustment program.

Brazil’s large, diverse and resource-rich economy further supports the ratings. These characteristics tend to reduce the severity of economic downturns. 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. In the decade to 2013, Brazil broadened the economic base by creating more inclusive growth.

In a context of normalizing U.S. monetary policy and weaker global demand, Brazil is well positioned to weather external shocks. This is due to its strong external balance sheet and relatively closed economy. External debt is manageable at 32.9% of GDP. The wide current account deficit, at 4.2% of GDP, reflects weak terms of trade. However, healthy net foreign direct investment inflows finance 88% of the current account deficit. Portfolio flows have been volatile, but a flexible exchange rate serves as a buffer to capital reversals and external shocks. Notwithstanding the Petrobras investigation, oil and gas discoveries have yet to be brought to market. Brazil has $372 billion of international reserves (17.3% of GDP), making the country a net public external creditor.

Another strength is Brazil’s solid framework for bank regulation and supervision, which reinforce financial stability and a stable banking system. The banking system is 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. Annual credit growth has slowed to 9.8%, including to the nascent real estate market. In the current environment of low growth, rising unemployment and tighter financial conditions, tighter lending conditions may be needed to preserve asset quality in public banks.

Notes:

A full rating report will be published in the coming days.

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 the National Treasury, Ministry of Finance, Planning Ministry, Central Bank of Brazil, Datafolha, Haver, IMF, DBRS. 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.

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.

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.

DBRS does not typically accept editorial changes other than to correct for factual, accuracy and/or to remove confidential, material non-public, or sensitive information that might otherwise be inadvertently disclosed.

Lead Analyst: Fergus McCormick
Rating Committee Chair: Roger Lister
Initial Rating Date: July 6, 2006
Most Recent Rating Update: August 1, 2014