DBRS Confirms Brazil at BB, Trend Remains Negative

DBRS, Inc. has confirmed Brazil’s Long-Term Foreign Currency – Issuer Rating at BB and Long-Term Local Currency – Issuer Rating at BB (high). The trend on both ratings is Negative. In addition, DBRS has confirmed Brazil’s Short-Term Foreign Currency – Issuer Rating at R-4 with a Stable trend and Short-Term Local Currency – Issuer Rating at R-3 with a Negative trend.

The rating confirmation reflects improvements in macroeconomic policymaking as well as advances in the government’s reform agenda. In the last 12 months, prudent monetary policy consolidated inflation at low levels and re-anchored inflation expectations around the target, Congress passed a constitutional amendment to cap the pace of government spending, and labor regulation was reformed to improve market flexibility. In addition, Brazil is exiting a deep recession, though the pace of recovery will likely be gradual. The economy is expected to grow 0.3% in 2017 and 1.3% in 2018.

The trend remains Negative, however, as recent political developments put the reform agenda at risk. Failure to pass pension reform in the near term would likely result in a downgrade of the ratings. Pension reform is essential to comply with the constitutional spending cap and stabilize public debt dynamics. Without pension reform, achieving fiscal consolidation targets will become increasingly difficult and will likely need to rely on measures that are less favorable to growth. Consequently, the outlook for public debt sustainability would likely weaken relative to our assumptions.

The principal challenge for Brazil’s credit profile is the fiscal deficit. The consolidated primary balance shifted from a surplus of 2.9% of GDP in 2011 to a deficit of 2.5% in 2016. While cyclical factors played a role, the deterioration was largely structural in nature. The Temer administration responded by implementing a gradual expenditure-based fiscal consolidation plan. If executed, DBRS estimates that the primary fiscal position will balance in 2021 and reach a surplus of 2.6% of GDP in 2026. Pension reform is essential, however, to comply with the constitutional expenditure ceiling and put fiscal accounts on a sustainable trajectory.

Given the gradual pace of fiscal consolidation, public debt dynamics are not expected to stabilize in the near term. Public debt-to-GDP is expected to increase to 82% in 2017 and 86% in 2018. The upward trajectory then moderates as the fiscal adjustment proceeds. Based on the projected fiscal consolidation path, debt ratios will peak at approximately 93% of GDP in 2023. The high stock of debt leaves little room to maneuver in the event of adverse shocks.

Recent developments in the Car Wash probe, however, threaten to derail the reform agenda. Last month, Prosecutor General Rodrigo Janot charged President Michel Temer with corruption. The Lower House is set to vote on whether to send the case to the Supreme Court in early August. While President Temer’s congressional support appears strong enough to fend off criminal prosecution for now, prospects for pension reform are diminishing. Coalition lawmakers are starting to position themselves ahead of the 2018 election. DBRS believes that pension reform is still possible later this year, but as the costs of aligning with an unpopular president rise, the reform’s narrow path to approval becomes even narrower.

The ratings reflect DBRS’s assessment that Brazil’s medium-term growth prospects are weak. The IMF projects that Brazil will expand on average 2.0% per year from 2019-2022, below most emerging market peers. Potential growth is hindered by interlinking structural constraints of low investment, high business costs and weak competitive forces. Over the last decade, investment averaged just 20% of GDP per year despite the rapid growth of earmarked lending. Underinvestment is especially evident in Brazil’s infrastructure. In particular, bottlenecks in transport infrastructure limit domestic market integration and weaken international competitiveness.

Productivity is also held back by the closed nature of the economy. Due in part to tariff barriers, high compliance costs, and inward-looking policy, trade penetration in Brazil is among the lowest in the world. The consequence of limited integration is that Brazil does not fully benefit from the potential efficiency gains derived from specialization and trade.

Notwithstanding Brazil’s challenges, the ratings are supported by several fundamental strengths. Brazil is a large and diversified economy with abundant natural resources. The banking system is sufficiently capitalized to digest higher credit losses without posing any systemic concerns. The external accounts are also sound from both a flow and stock perspective, with a flexible exchange rate facilitating adjustments to global conditions.

In addition, the government has made progress on the policy front. The central bank is easing monetary policy amid a substantially improved inflation outlook. Inflation declined to 3.0% in June 2017 after peaking at 10.7% in January 2016. The disinflation trend is generalized, with most categories of goods and services experiencing annual price increases at or below the inflation target. Inflation expectations have also settled around the target. Enhanced credibility combined with the tapering of earmarked lending should strengthen the effectiveness of monetary policy.

The Temer administration is also taking steps to improve the investment climate. Regulatory changes aim to reinvigorate infrastructure concessions, on-lending by public banks is being wound down, and restrictions in the oil and gas sector have been eased. Nevertheless, given the importance of fiscal consolidation in the near term, implementation of a broader reform agenda will likely depend on the next administration.

RATING DRIVERS
Failure to pass pension reform in the near term would likely result in a downgrade of the ratings. On the other hand, the trend could be changed to Stable if a reform is passed that materially slows the pace of pension spending and lends credibility to the fiscal adjustment plan.

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 at http://www.dbrs.com/about/methodologies.

The sources of information used for this rating include Banco Central do Brasil, Secretaria do Tesouro Nacional, Instituto Brasiliero de Geografia e Estatística, IMF, WTO, UNDP, World Bank, Tullet Prebon Information, The Conference Board Total Economy Database (Adjusted Version) - May 2017, Banco de Mexico, Banco de la República, Banco Central de Chile, JPMorgan, FUNCEX, NRGI, Brookings, and Haver Analytics. 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, Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas Torgerson, Senior Vice President, Global Sovereign Ratings
Initial Rating Date: 6 July 2006
Last Rating Date: 1 August 2016