DBRS Downgrades Brazil to BB (high), Negative Trend

DBRS, Inc. has taken the following action on the Federative Republic of Brazil:

• Downgraded the long-term foreign currency issuer rating to BB (high) from BBB (low) and changed the trend to Negative from Stable.
• Downgraded the long-term local currency issuer rating to BBB (low) from BBB and changed the trend to Negative from Stable.
• Downgraded the short-term foreign currency issuer rating to R-3 from R-2 (middle) and changed the trend to Negative from Stable.
• Downgraded the local currency issuer rating to R-2 (middle) from R-2 (high) and changed the trend to Negative from Stable.

Elements that drove this action were: (1) high and rising political uncertainty from a corruption probe into a graft scheme surrounding state oil company Petróleo Brasileiro S.A. (Petrobras), which has caused political paralysis, (2) an inadequate fiscal policy response, evident in a stalled fiscal adjustment and structural reform effort, and (3) the reduction in economic activity over the last four quarters, and erosion of social gains, with few signs of recovery. These factors have resulted in a loss of macroeconomic stability, a sharp increase in the fiscal deficit, and worsening debt dynamics.

If political uncertainty continues and the fiscal policy response remains inadequate, debt dynamics would likely continue to worsen and the ratings would come under downward pressure. Alternatively, a more stable political environment and policy action that demonstrates a bigger commitment to fiscal consolidation, could result in stronger economic activity and a stabilization of the ratings.

The corruption probe, now approaching its two year mark, has broadened to senior policymakers and legislators, including a filing of charges by São Paulo state prosecutors for the arrest of former President Luiz Inácio Lula da Silva for allegedly concealing his ownership of a luxury beachside apartment. In parallel, an auditing tribunal has ruled that President Dilma Rousseff improperly used funds from state banks to cover budget shortfalls. This has led to impeachment proceedings. The Federal Electoral Court is also conducting a review of President Rousseff’s campaign finances. The scope of the probe has revealed a much greater level of corruption than DBRS had previously assessed. Several opposition lawmakers – many of whom are also under investigation – have threatened to block all legislation until the impeachment proceedings against President Rousseff move ahead. Popular demonstrations for and against the President continue, suggesting that social discord is on the rise. Taken together, these events suggest that coordinated action on policy to address the fiscal and economic weakness has become more uncertain.

The knock-on effects of the corruption probe to real economic activity appear to have been significant. This is partly a result of the increasing number of high profile executives indicted across various sectors, and partly from a decline in consumer and business confidence to historic lows. Combined with the decline in world commodity prices, which has resulted in a 21.7% fall in Brazilian exports since August 2011, the collapse in all components of domestic demand caused real GDP to decline by 3.8% in 2015. Consensus forecasts point to a decline of 3.5% in 2016.

Unemployment has increased to 9% and is likely to continue rising. Notwithstanding a recent strengthening of the currency, low confidence has led to significant Real depreciation, contributing to upward pressure on domestic prices. Consumer price inflation stood at 10.4% in February 2016. The Central Bank of Brazil hiked overnight interest rates to 14.25% through July 2015 and has kept the target constant since then. Tighter monetary policy is helping to stabilize inflation. However, anchoring inflation expectations is proving to be challenging.

The poor fiscal and structural policy response to the crisis contributed to a deterioration in the general government deficit to 10.3% of GDP in 2015. The primary balance, targeted at 0.15% of GDP in July 2015, declined to a deficit of 1.9% of GDP by yearend. Tighter financial conditions have resulted in sharply higher bond yields, thereby increasing the cost of financing the public debt. These factors resulted in an increase in gross public sector debt to 66.2% of GDP in 2015 from 57.2% in 2014.

In the months ahead, one of two paths is likely to be taken. The first path is that political tensions continue, stalling fiscal consolidation and reform initiatives. The adoption of a fiscal adjustment program would be a signal of a stronger commitment to resolving the crisis, and would likely be needed to restore confidence. In the absence of fiscal adjustment, the economy is likely to remain in recession. A very slow fiscal adjustment could eventually result in a return to growth.

A second path involves a political change caused by one of several events. These could include the TSE electoral court ruling that irregularities in the 2014 re-election campaign of President Rousseff amount to an abuse of power, thereby invalidating the election. This could result in the calling of new elections, or an impeachment of the President. A political change could also occur if Congress impeaches the President over the use of state bank financing to plug a hole in the 2014 budget. Alternatively, President Rousseff could resign. Any of these changes would likely result in a transfer of presidential power, and an eventual fiscal adjustment and reforms. At this point, there is limited visibility on which path will be taken, but events over the next few months are expected to gradually provide more clarity on the direction that the country is taking. As far-reaching as it is, the corruption investigation is a testament to the strengthening of Brazilian institutions. This has become an important supporting factor for the ratings.

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, Datafolha, IMF, World Bank, Haver Analytics, 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 19, 2015