DBRS Downgrades Brazil to BB, Negative Trend

DBRS, Inc. has today downgraded the Federative Republic of Brazil’s long-term foreign currency issuer rating to BB and the long-term local currency issuer rating to BB (high). The trend on both long-term ratings is Negative. DBRS has also downgraded the short-term foreign currency issuer rating to R-4 with a Stable trend and the short-term local currency issuer rating to R-3 with a Negative trend.

The one-notch downgrade reflects the scale of Brazil’s fiscal challenge. The primary deficit is projected to widen to 2.6% of GDP in 2016, materially larger than expectations during DBRS’s last review in March 2016. Due to the high share of mandatory and indexed spending, reversing the fiscal trajectory will require fundamental budgetary reforms. The interim government is designing a gradual expenditure-based consolidation plan, which includes a constitutional amendment to cap spending growth to the rate of inflation. Based on this proposal, DBRS estimates that the primary fiscal position will balance in 2020 and reach a surplus of 2.0% of GDP in 2025.

Given the gradual pace of fiscal consolidation, public debt dynamics could take a decade to stabilize. General government debt-to-GDP is expected to increase to 88% by 2020 and continue rising through 2025, although the upward trajectory will moderate as the fiscal adjustment proceeds. This highlights the extent of the challenge ahead for Brazil: fiscal policy will need to be defined by expenditure control and tax increases for the next two and a half presidential terms. Moreover, the high stock of public debt leaves little room to maneuver in the event of adverse shocks.

Risks to the ratings remain skewed to the downside. The level of political uncertainty is still elevated despite improved visibility in recent months. It is DBRS’s baseline assumption that the Senate will vote in favor of President Rousseff’s impeachment and the interim government will fulfill the term through 2018. Nevertheless, fallout from the Car Wash investigations and a potential ruling by the Electoral Court to annul the 2014 elections pose downside risks. In addition, the Temer administration could have difficulty navigating major budgetary reforms through Brazil’s fragmented Congress, particularly as attention turns to social security reform.

The BB ratings reflect DBRS’s assessment that Brazil’s medium-term growth prospects are weak. The IMF projects that Brazil will expand on average 1.8% per year from 2018-2021, well below most emerging market peers. The poor outlook reflects interlinking structural constraints of low investment, high business costs and weak competitive forces. Over the last decade, investment averaged just 20.6% of GDP per year even as the rapid growth of earmarked lending contributed to capital misallocation. Underinvestment is evident in Brazil’s large infrastructure gap. High business costs also stem from a distortionary tax system, which undermines productivity and weakens incentives to invest.

Potential productivity gains are also held back by the closed nature of the Brazilian economy. Trade penetration in Brazil is among the lowest in the world. This partly reflects tariff barriers, high compliance costs and inward-looking trade policy. Consequently, Brazil is not fully benefiting from potential efficiency gains derived from specialization and global integration.

Notwithstanding these political and economic challenges, the ratings are underpinned by several credit strengths. Brazil is a large and diversified economy with abundant natural resources. The external accounts are sound from a flow and stock perspective: the current account deficit has narrowed to modest levels, external liabilities are moderate, and a flexible exchange rate has facilitated an adjustment amid weaker terms of trade. Furthermore, the banking system appears sufficiently capitalized to digest higher credit losses without posing systemic concerns.

In DBRS’s view, recent policy actions to address macroeconomic imbalances could stabilize the ratings in the near term. Though gradual, the deficit-reduction strategy should anchor expectations and put the fiscal trajectory on a more sustainable path. At the same time, tight monetary policy is guiding inflation toward the central bank’s target and helping re-anchor inflation expectations. A credible political commitment to sound macroeconomic policy should reduce downside risks to the growth outlook and support the recovery.

The Temer administration is also shifting economic policy toward a more market-based approach. The shift includes reinvigorating infrastructure concessions through regulatory changes, reducing distortions in credit markets, easing restrictions on foreign investment in the oil and gas sector, and showing a renewed interest in global integration. However, given the immediate concern of restoring fiscal sustainability, implementation of a broader structural reform agenda will likely depend on the next administration.

There are some early signs that Brazil’s deep recession is starting to moderate. In the last three months, business and consumer confidence marginally improved, industrial production stabilized, and export volumes continued to expand at a strong pace. However, the pace of recovery will likely be slow, as contractionary fiscal and monetary policy, private sector deleveraging, and worsening labor market conditions impede a more rapid rebound. The IMF estimates that GDP will contract 3.3% in 2016 and return to growth of 0.5% in 2017.

RATING DRIVERS
If unanticipated political developments derail the interim government’s fiscal policy agenda, the ratings could be downgraded. However, if political risks subside and the government advances measures underpinning the fiscal adjustment plan, the trend could be changed to Stable.

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. These can be found on www.dbrs.com at:
http://www.dbrs.com/about/methodologies

The sources of information used for this rating include the National Treasury, Banco Central do Brasil, Instituto Brasileiro de Geografia e Estatística, Banco Central de Chile, Banco de la República, Banco de México, IMF, WTO, World Bank, The Conference Board Total Economy Database (May 2016), JPMorgan, FUNCEX, Haver Analytics, DBRS. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the rating process. DBRS did not have access to the accounts and other relevant internal documents of the rated entity or its related entities.

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.

Lead Analyst: Michael Heydt
Rating Committee Chair: Roger Lister
Initial Rating Date: 6 July 2006
Most Recent Rating Update: 15 March 2016