DBRS Downgrades Brazil to BB (low), Trend Changed to Stable

DBRS, Inc. has downgraded Brazil’s Long-Term Foreign and Local Currency – Issuer Ratings to BB (low) from BB. The trend on both ratings has been changed to Stable from Negative. In addition, DBRS has confirmed Brazil’s Short-Term Foreign and Local Currency – Issuer Ratings at R-4 and maintained the Stable trends.

The downgrade to BB (low) reflects the deterioration in Brazil’s public debt sustainability outlook due to delays in passing pension reform. Absent reform, the implementation of a structural fiscal adjustment will be increasingly difficult to achieve and will likely need to rely on measures that could weaken medium-term growth prospects. The Stable trend indicates that upside and downside risks to the ratings are now balanced. Recent positive developments, such as improved monetary policy credibility, reformed credit markets and stronger household balance sheets, put the economy in a better position to grow. Nonetheless, Brazil’s outlook depends in large part on the implementation of a credible deficit-reduction plan following the 2018 elections.

The BB (low) ratings benefit from several fundamental strengths. Brazil is a large and diversified economy, which enhances its resilience to sector or region specific shocks. Financial stability concerns are limited due to a well-capitalized and profitable banking system. Moreover, exchange rate flexibility helps the economy adjust to changing global conditions.

However, the key constraint to the ratings is the large budget deficit and rising public debt burden. Without corrective policy action, the fiscal trajectory is unsustainable. Public finance concerns are compounded by Brazil’s weak medium-term growth outlook. Prospects for policy action to address fiscal imbalances and increase potential growth are unclear ahead the October 2018 elections.

FISCAL DYNAMICS ARE UNSUSTAINABLE WITHOUT CORRECTIVE ACTION

The most pressing issue facing Brazil’s sovereign credit profile is the fiscal deficit. The primary balance deteriorated significantly from 2011 to 2016. This was largely due to rising spending. In response, the Temer administration designed an expenditure-based fiscal consolidation plan underpinned by a constitutional amendment that limits the growth of primary spending to the rate of inflation. Compliance with this spending cap was achieved in 2017. The primary deficit narrowed to 1.7% of GDP from 2.5% the previous year. Spending will likely come in below the cap in 2018 as well. However, the improving headline figure masks a deteriorating structural outlook. Given the high share of spending that is constitutionally protected or indexed to the minimum wage, mandatory spending pressures continue to build.

In particular, the size and direction of pension spending makes reform essential. Pension spending is responsible for a large share of total government expenditures and it is quickly rising due to Brazil’s aging population and the regime’s generous benefits. Without reform, rising mandatory spending will become incompatible with the constitutional spending cap. In February 2018, the Temer administration withdrew its reform proposal amid insufficient congressional support, leaving the next administration with limited room to maneuver. The savings lost by not reforming the system will need to be offset by commensurate expenditure cuts elsewhere, a prospect that could be both economically inefficient and politically challenging.

Public debt dynamics are not expected to stabilize in the near term. Assuming future governments comply with the spending cap, DBRS estimates that the primary balance would shift to a surplus in 2021 and then rise to 1.9% of GDP in 2025. In such a scenario, gross non-financial public sector debt (based on IMF definition) would peak in 2025 at around 98% of GDP and then gradually decline. This does not consider cumulative prepayments from BNDES in 2017 and 2018 (totaling nearly 3% of GDP) that could reduce gross debt. Stronger growth on the back of corrective policy action and economic reforms could also materially improve the debt sustainability outlook. On the other hand, if the fiscal adjustment does not proceed in a manner that is consistent with the spending cap, public debt ratios would continue to rise, thereby jeopardizing the sustainability of public finances and, potentially, macroeconomic stability.

PROSPECTS FOR POLICY ACTION ARE UNCERTAIN IN THE POST-ELECTION ENVIRONMENT

Prospects for corrective fiscal policy action and structural reforms following the October 2018 general election are uncertain. The field of presidential candidates is still unsettled. The most popular potential candidate, former president Luiz Inácio Lula da Silva of the Workers’ Party, could be prevented from running due to recent court rulings. Widespread dissatisfaction with the political elite could also create space for anti-establishment candidates to mount competitive runs. At this point, candidates’ policy platforms are largely undefined. However, even if the next president is committed to fiscal consolidation, party fragmentation in Brazil’s congress will make it difficult for the next administration to build a coalition large enough to pass legislation, particularly pension reform which requires amending the constitution.

The Car Wash investigations have revealed widespread corruption but also highlighted some of Brazil’s institutional strengths. According to the World Bank Governance Indicators, Brazil compares poorly to many other emerging economies in the area of corruption control. However, Brazil’s institutional response to corruption in recent years is encouraging. The investigations themselves are the product of a strong and independent judiciary, which has been supported by an active civil society and vibrant media. One legacy of the Car Wash probe could also be better corporate governance. Legislation such as the Clean Companies Act (2014) and the State Companies Law (2016) aim to strengthen anti-bribery laws, enhance transparency, and improve risk management practices.

ECONOMY IS RECOVERING BUT MEDIUM-TERM GROWTH PROSPECTS ARE WEAK

The economy is recovering from a deep and prolonged recession. GDP expanded 1.0% in 2017 and it is expected to grow 1.9% in 2018. Although the cyclical recovery is advancing, Brazil’s medium-term growth prospects are comparatively weak. The IMF projects that Brazil will expand on average 2.0% per year from 2019-2022, below most emerging market peers. The poor outlook partly reflects demographics, but interlinking structural constraints of low investment, high business costs and weak competitive forces also play a role. Low investment is especially evident in Brazil’s underdeveloped infrastructure, which holds back productivity. At the same time, Brazil does not fully benefit from the potential efficiency gains derived from specialization and trade on account of high tariff barriers, elevated compliance costs, and inward-looking policy.

The Temer administration has taken measures to improve the investment climate. In September 2017, congress passed a law that gradually aligns directed lending rates with market rates. This should improve credit allocation and enhance budget transparency. In July 2017, congress passed labor reform, which should make the jobs market more flexible and encourage greater formalization. The government also eased restrictions in the oil and gas sector and scaled back local content rules, making the sector more attractive to foreign capital. Nevertheless, the implementation of a broader structural reform agenda that strengthens Brazil’s medium-term growth outlook will depend on the next government.

INFLATION AND EXTERNAL OUTLOOKS HAVE IMPROVED AND BANKING SYSTEM IS SOUND

The inflation outlook has significantly improved. Prudent monetary policy has consolidated inflation at low levels and anchored inflation expectations around the target. Inflation was 2.8% (yoy) in February 2018, down from 10.4% two years earlier. In the context of a more benign inflation outlook and a negative output gap, the central bank has eased monetary policy substantially to support the recovery. The policy rate has declined by 750 basis points since October 2016. Enhanced credibility combined with the tapering of directed lending should strengthen the effectiveness of monetary policy.

Asset quality in the banking system has deteriorated but risks to financial stability appear contained. The delinquency rate for firms is still above pre-recession levels. Corporate debt levels are high, albeit declining, and demand conditions remain weak. However, credit quality issues have not generated stability concerns. Even if the recovery is slower than expected, the banking system appears sufficiently capitalized to digest additional credit losses without any major disruption. Provisioning levels are high, and capital buffers are well above the regulatory minimum.

In addition, Brazil’s external accounts do not exhibit any clear imbalances. Gross external liabilities are moderate, the current account deficit is modest, and inflows of net foreign direct investment provide a stable source of external financing. Moreover, exchange rate flexibility facilitates Brazil’s adjustment to global conditions. In the event of an external shock, the central bank has a large stock of reserves to provide foreign exchange liquidity if necessary.

RATING DRIVERS

The ratings could experience downward pressure if the next administration does not address Brazil’s structural fiscal imbalances. Large external shocks that materially weaken Brazil’s medium-term growth outlook could also weigh on the ratings.

Alternatively, the ratings could experience upward pressure if the next administration implements a credible fiscal consolidation plan, underpinned by a reform that materially slows the pace of pension spending. The structural nature of such an adjustment would lend credibility to the plan, which could strengthen confidence, lower real interest rates and accelerate the recovery. Economic reforms that improve the investment outlook and facilitate Brazil’s integration into global markets would also be credit positive.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the BB (high) to BB (low) range. The main points discussed during the Rating Committee include: 1) the fiscal outlook, 2) the 2018 general election, and 3) the impact of economic reforms and policy changes.

KEY INDICATORS
Fiscal Balance (% GDP): -10.2% (2016); -7.8% (2017); -8.0% (2018F)
Gross Debt (% GDP): 78.3% (2016); 83.4% (2017F); 87.7% (2018F)
Nominal GDP (USD billions): 1,806 (2016); 2,055 (2017); 2,200 (2018F)
GDP per capita (USD thousands): 8.7 (2016); 10.0 (2017); 10.5 (2018F)
Real GDP growth (%): -3.5% (2016); 1.0% (2017); 1.9% (2018F)
Consumer Price Inflation (%, eop): 6.3% (2016); 2.9% (2017); 4.0% (2018F)
Domestic credit (% GDP): 49.6% (2016); 47.1% (2017); 46.6% (Jan-2018)
Current Account (% GDP): -1.3% (2016); -0.5% (2017); -1.8% (2018F)
International Investment Position (% GDP): -32.3% (2016); -33.5% (2017)
Gross External Debt (% GDP): 30.4% (2016); 26.6% (2017)
Foreign Exchange Reserves (% short-term external debt + current account deficit): 302% (2016); 262% (2017)
Governance Indicator (percentile rank): 53.7 (2016)
Human Development Index: 0.754 (2015)

Notes:

All figures are in U.S. dollars unless otherwise noted. Fiscal Balance and Gross Debt figures are reported for the non-financial public sector (NFPS) and based on the IMF definition. NFPS debt includes central, state, and local governments, and social security funds; it excludes the central bank, state-owned enterprises, Petrobras, and Eletrobras. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/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 at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include Banco Central do Brasil, Secretaria do Tesouro Nacional, Instituto Brasiliero de Geografia e Estatística, Fundaçâo Instituto de Pesquisas Econômicas, IMF, UNDP, World Bank, Bank for International Settlements, Tullet Prebon Information, JPMorgan, FUNCEX, NRGI, Brookings, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be 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 for this rating action. DBRS did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

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: Roger Lister, Managing Director, Chief Credit Officier – Global FIG and Sovereign Ratings
Initial Rating Date: 6 July 2006
Last Rating Date: 28 November 2017

Information regarding DBRS ratings, including definitions, policies and methodologies, is available on www.dbrs.com.