DBRS Inc. (DBRS Morningstar) confirmed the Federative Republic of Brazil’s Long-Term Foreign and Local Currency – Issuer Ratings at BB (low). At the same time, DBRS Morningstar confirmed the Federative Republic of Brazil’s Short-term Foreign and Local Currency – Issuer Ratings at R-4. The trend on all ratings is Stable.
KEY RATING CONSIDERATIONS
The Stable trend reflects our view that Brazil’s gradually improving credit fundamentals prior to the outbreak of the Coronavirus Disease (Covid-19) have been set back by the marked deterioration in the country’s near-term growth outlook and public finances.
The Covid-19 pandemic has had a severe impact on the Brazilian economy. In March and April, domestic demand dropped sharply due to mandated lockdowns and weaker confidence, commodity prices declined on soft external demand, and financing conditions tightened amid heightened risk aversion globally. Overall, the economy contracted abruptly by 6.9% in the first half of 2020 relative the last six months of 2019. High frequency data suggests that a recovery has begun. Activity started to rebound in May, and domestic equity and bond prices have partially recouped earlier losses. We expect growth to pick up in the second half of the year, supported by highly expansionary fiscal and monetary policies. According to the August 28th FOCUS survey, GDP is expected to decline by 5.3% in 2020 and then expand by 3.5% in 2021. However, recovery prospects are highly uncertain and could depend on the evolution of the virus, which continues to spread at an elevated rate across the country.
The task of putting Brazil’s public finances on a sustainable path has become more challenging in the aftermath of the outbreak. Emergency spending to support the economy will contribute to a very large fiscal deficit in 2020. We expect the government to resume its deficit-reduction strategy in 2021 as stimulus measures expire. However, compliance with the constitutionally-mandated spending cap, which requires tight fiscal control and expenditure reforms, will be challenging in the wake of a recession and intensifying public demands for increased social transfers. Even if the government complies with the spending cap, the pace of consolidation will likely be slower than we previously assumed and the public debt-to-GDP ratio will stabilize at a substantially higher level.
Putting public finances on sustainable path and lifting the country’s medium-term growth prospects hinge on implementing structural reforms. Passage of pension reform last fall was a major legislative achievement. Congress is now turning its attention to tax reform, with several proposals under discussion. Notwithstanding this progress, it is not clear whether there is the political willingness and capacity to push through a broader reform agenda, including reforms to reduce fiscal rigidity and bolster public sector efficiency.
Policy actions in the years prior to the outbreak – including the introduction of a spending cap, improvements in the credibility of monetary policy, reforms to the credit markets, and passage of the pension reform – were positive developments and set the stage for a gradual improvement in Brazil’s credit profile, particularly if the reform momentum could be sustained. However, following the virus outbreak, we view the upside and downside risks to Brazil’s BB (low) ratings as more broadly balanced. On the one hand, the recovery could gain momentum once the pandemic passes if confidence builds on the back of a credible deficit-reduction strategy and an advancing reform agenda. Under such conditions, the outlook for debt sustainability could materially improve. On the other hand, political support for the fiscal adjustment could weaken, thereby leaving Brazilian public finances in an unsustainable position and vulnerable to destabilizing shocks.
The ratings could be upgraded if the government advances a credible fiscal consolidation plan, thereby fostering lower real interest rates and improving the outlook for public debt sustainability. Economic reforms that strengthen the growth outlook would facilitate this adjustment and be viewed as credit positive.
The ratings could be downgraded if the commitment to fiscal consolidation weakens or there is a material deviation from the expected consolidation path. Additional shocks – either domestic or external – that exacerbate Brazil’s growth challenges could make the necessary fiscal adjustment even more difficult to achieve.
Large Fiscal Expansion Is Providing Relief But Consolidation Post-Virus Is Required To Ensure Sustainability
Emergency fiscal measures to address the public health response and support the economy have interrupted Brazil’s deficit-reduction strategy. The government estimates that the primary deficit for the public sector will reach 11.3% of GDP in 2020, up from the original deficit target of 1.7%. The deterioration is being largely driven by higher spending, although the cyclical impact on revenues is also contributing. Support measures are expected to total 7.5% of GDP, with cash transfers to low-income families comprising the largest single stimulus item.
While we expect Brazil to resume an expenditure-based consolidation strategy in 2021, the fiscal outlook has become more challenging. The emergency expenses incurred in response to the pandemic are temporary and should run their course this year. This, combined with a cyclical recovery in the economy, should lead to a large improvement in the fiscal balance next year. Nevertheless, pursuing a consolidation strategy guided by the constitutional spending cap will result in a more gradual adjustment than assumed prior to the pandemic given the economy’s weaker expected growth path. Moreover, compliance with the spending cap will require reforms, especially since a high share of spending is mandatory and either earmarked or indexed. The 2019 pension reform alleviated some pressure on mandatory expenditure by stabilizing pension outlays as a share of GDP. In this regard, the reform was a major legislative accomplishment. However, lowering the spending-to-GDP ratio will require additional reforms to make the spending profile more flexible.
The massive primary deficit in 2020 combined with the impact of the recession will lead to a large increase in public debt. Overall, we consider the risks to public debt sustainability to be high. Assuming the emergency fiscal measures expire in 2020 and the government complies with the spending cap going forward, we estimate that the primary deficit would shift to a small surplus in 2026. In such a scenario, gross non-financial public sector debt (based on IMF definition) would jump 18 percentage points in 2020 to 108% of GDP and then increase marginally each year through 2026, when the debt ratio would peak at 112%. Importantly, this scenario does not include potential extraordinary receipts, such and BNDES repayments or privatization proceeds, that could limit the increase in the debt ratio.
Risks to the outlook are two-sided. In a positive scenario characterized by stronger growth and lower borrowing costs, the debt ratio would increase to 105% in 2020, stabilize at that level through 2023, and then gradually decline from 2024 to 2026 as the fiscal adjustment advances. Alternatively, if spending is not tightly controlled and the recovery fails to gain momentum, public debt ratios could remain on an upward trajectory, thereby jeopardizing the sustainability of public finances and, potentially, macroeconomic stability.
Brazil’s Growth Prospects Are Weak And Progress On the Reform Agenda Has Been Slow
Prior to the pandemic, the IMF estimated potential growth at just 2.2%. With potential scarring effects from the coronavirus shock, we view the risks to this assessment as skewed to the downside. The poor outlook partly reflects a slowdown in the growth of Brazil’s labor force as the population ages. However, interlinking structural constraints of low investment, high business costs and weak competitive forces are also playing a role. Low investment is especially evident in Brazil’s underdeveloped infrastructure. High tariff barriers, elevated compliance costs, and inward-looking industrial policy also impede Brazil from more fully benefiting from global trade. The country’s poor medium-term growth outlook has led us to make a negative adjustment in the “Economic Structure and Performance” building block assessment.
Implementation of the government’s pro-market reform agenda could improve growth prospects over the medium term. Reforms include rationalizing tax policy, overhauling public administration, lowering the cost of doing business, pursuing privatizations, and opening the economy to international competition. The agenda has notional support from Congress and the Bolsonaro administration. Several important reforms have already been passed, including the pension reform. However, progress on the broader agenda has been slow. To some extent, the pandemic has recently overshadowed other legislative priorities, but implementation also appears to be encumbered by heightened tensions between the President and Congress as well as divisions within the Bolsonaro administration itself. Efforts to advance reforms could also be complicated by the political calendar; nationwide municipal elections are scheduled for November 2020 and a new speaker of the lower house will be elected in February 2021.
Brazil’s Credit Strengths: Anchored Inflation Expectations, Well-Capitalized Banks, And Solid External Accounts
The central bank has aggressively responded to the economic and financial market shock with highly expansionary monetary policy, expanded liquidity operations, and credit-enhancing measures. From February to August, the central bank cut the policy rate by 225 basis points to an all-time low of 2.0%. Monetary policy will likely remain in highly expansionary territory for an extended period of time given the large output gap and subdued inflation dynamics. On an institutional level, the central bank has reinforced its inflation-targeting credibility with the markets over the last four years, as reflected in medium-term inflation expectations anchored around the target. This, combined with the tapering of directed lending, should strengthen the effectiveness of monetary policy over time.
While the recession will hit banks’ asset quality and profitability, strong capitalization combined with the central bank’s liquidity operations should help Brazilian banks weather the Covid-19 shock without any major disruption. Banks are renegotiating loans for those households and businesses that have been adversely impacted by the virus but were in good standing prior to the shock. Depending the extent of the deterioration in asset quality, loan restructurings will require higher provisioning. Banks appear sufficiently capitalized to digest greater credit losses, particularly the larger banks with well-diversified loan portfolios. The central bank has also expanded liquidity facilities to allay potential funding stresses and lowered capital requirements to support lending to creditworthy borrowers. Banks’ direct exposure to exchange rate risk is minimal, and secondary effects on asset quality appear contained thus far.
On the external front, heightened global risk aversion following the Covid-19 outbreak led to a large and abrupt pullback of foreign capital to emerging markets. Brazil’s equity and debt markets experienced massive outflows in March and April. However, the country has weathered the shock relatively well so far, due in part to its flexible exchange rate and sound external position. The current account deficit is modest and narrowing, an adjustment that is being facilitated by a weaker exchange rate. Public and private external debt are also at moderate levels, thereby reducing risks to balance sheets across the economy stemming from currency fluctuations. Moreover, sizable reserves (20% of GDP) and a $60 billion dollar swap line with the U.S Federal Reserve provide the central bank with substantial resources to mitigate the impact of potential capital flow volatility on the real economy.
Resource & Energy Management (E), Human Capital & Human Rights (S), Bribery, Corruption & Political Risks (G), Institutional Strength, Governance & Transparency (G), and Peace & Security (G) were among key drivers behind this rating action. Management of resource and energy sectors could be a potential vulnerability to the Brazilian economy, with agriculture and extractive industries accounting for 7-8% of overall activity. Similar to other emerging market economies and many of its regional peers, per capita GDP is relatively low, at US$8.8k (US$16.5k on a PPP basis). According to World Bank Governance Indicators, Brazil ranks in the 41st percentile for Control of Corruption, the 45th percentile for Rule of Law, and the 37th percentile for Government Effectiveness. Brazil also ranks low (32nd percentile) on Political Stability and the Absence of Violence/Terrorism. These considerations have been taken into account within the following Building Blocks: Fiscal Management & Policy Economic Structure & Performance, and Political Environment.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments.
All figures are in U.S. dollars unless otherwise noted. Public finance statistics reported on a general government basis unless specified. 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 Electrobras.
For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.
The principal methodology is the Global Methodology for Rating Sovereign Governments,
https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (July 27, 2020)
The primary 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, World Federation of Exchanges, Tullet Prebon Information, NRGI, Brookings, and Haver Analytics. DBRS Morningstar 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 for this rating action. DBRS Morningstar 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.
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