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 confirmation of the BB (low) ratings balances Brazil’s fiscal challenges and weak medium-term growth prospects with the country’s credible monetary policy regime, sound financial system, and strong external position.
The Brazilian economy performed surprisingly well in the first half of 2021 given the severity of the health situation. The recovery has been supported by the economic reopening, expansionary macroeconomic policies, and improving terms of trade. A strengthening labor market and progress on vaccinations should bolster confidence in the second half of the year. Over 60% of the population has received at least one dose and 30% are fully vaccinated. However, the pace of recovery is likely to be moderate over the remainder of the year and into next year, as the reopening effects fade and expansionary policies are withdrawn. According to the central bank’s August 30th FOCUS survey, the median forecast for GDP growth is 5.2% in 2021 and 2.0% in 2022. In DBRS Morningstar’s view, risks to the near-term outlook are skewed slightly to the downside, due to the global spread of the Delta variant as well as the possibility of stronger inflation pressures.
The task of putting public finances on a sustainable path remains the central credit challenge for Brazil. Fiscal outcomes are set to improve markedly this year, as most pandemic-related measures expire and tax receipts increase on the back of a rebound in activity and favorable commodity prices. However, compliance with the constitutional spending cap, which requires tight fiscal control and structural reforms, will be increasingly difficult for the next administration, particularly amid public demands for greater social spending.
The Stable trend reflects DBRS Morningstar’s views the upside and downside risks to the BB (low) ratings are broadly balanced. A general election is scheduled for October 2022. The evolution of the ratings could depend on the willingness and ability of the next administration to pass reforms. Growth prospects could strengthen if confidence builds on the back of a credible deficit-reduction strategy and economic reform agenda. Under such conditions, the outlook for debt sustainability could materially improve. On the other hand, political support for the fiscal adjustment may 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 sustaining 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.
The Most Important Policy Issue Facing Brazil’s Sovereign Credit Profile Is Consolidating Fiscal Accounts
Fiscal outcomes are expected to improve significantly in 2021, but the task of putting public finances on a sustainable path will likely require five more years of tight spending control. The consolidated public sector primary deficit widened from 0.8% of GDP in 2019 to 9.4% in 2020, as the government implemented emergency measures to address the public health crisis and support the economy. Pandemic-related spending measures totaled 7.0% of GDP last year, with cash transfers to low-income families comprising the largest single stimulus item. However, the fiscal outcome in 2021 is set to improve markedly. In the first six months of the year, primary spending declined sharply as most emergency measures were unwound, and as tax collection benefited from higher commodity prices and a recovery in economic activity. The government estimates a primary deficit of 1.8% of GDP for the year, which is broadly in line with the market consensus.
Notwithstanding the positive results in the first half of the year, compliance with the constitutional spending cap, which is Brazil’s key fiscal anchor, will be increasingly difficult over time. In the near term, two factors will reduce the government’s room to maneuver in 2022: high inflation at the end of this year, which will feed through to higher mandatory spending, and sizable court-ordered payments arising from debts owed by the Treasury, which recently came in well above expectations. DBRS Morningstar expects that the government will be able to meet the cap in 2022, but given the high share of expenditure that is mandatory and either earmarked or indexed, compliance with the cap will become more difficult in the coming years. The 2019 pension reform alleviated some pressure on mandatory spending 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 pandemic-induced recession and fiscal response has pushed public debt levels markedly higher. Gross non-financial public sector debt (IMF definition) jumped from 88% of GDP in 2019 to 99% in 2020. Assuming the government complies with the spending cap through 2026, DBRS Morningstar estimates that the primary deficit will shift to a balanced position in 2024 and then reach a surplus of 1.0% of GDP in 2026. In such a scenario, the debt-to-GDP ratio would decline to 96% in 2021 on the back of strong growth, but it would then rise gradually through 2025 when it would peak at 100%. Importantly, this scenario does not include potential extraordinary receipts, such as BNDES repayments or privatization proceeds, nor does it include the potential drawdown of the government’s sizable liquid assets, all of which could reduce the gross debt ratio.
Overall, DBRS Morningstar considers debt sustainability risks to be high. If the next administration does not sustain fiscal consolidation efforts, the debt ratio would continue on an upward trajectory, thereby jeopardizing the sustainability of public finances and, potentially, macroeconomic stability. Tighter financing conditions or rising risk premiums could also exacerbate debt dynamics. The vulnerability of public finances to shocks highlights the importance of pursuing a credible consolidation strategy that reinforces market confidence and sustains access to affordable borrowing.
Growth Prospects Are Weak And The 2022 Election Clouds The Outlook For Fiscal Consolidation And Reforms
While Brazil is recovering from the shock of the pandemic, the country’s medium-term growth prospects are weak. The IMF estimates potential GDP growth at around 2 percent. 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 also play a role. Low investment is especially evident in Brazil’s underdeveloped infrastructure. In addition, high tariff barriers, elevated compliance costs, and inward-looking industrial policy impede Brazil from more fully benefiting from global trade and investment. The country’s weak medium-term growth outlook has led us to make a negative adjustment in the “Economic Structure and Performance” building block assessment.
Uncertainty around the 2022 general election clouds the outlook for fiscal consolidation and structural reforms. In DBRS Morningstar’s view, the government’s pro-market reform agenda – including rationalizing tax policy, overhauling public administration, and lowering the cost of doing business – is unlikely to make much progress in the run-up to the October 2022 election. Moreover, it is far from clear what the political landscape will look like after the election and how conducive it will be to passing reforms, particularly given Brazil’s fragmented party system and increasing social polarization. Recent polls show President Bolsonaro trailing former president Lula Inacio da Silva by a sizable margin. However, the election is more than a year away and the field of candidates is still unsettled. High disapproval rates for both President Bolsonaro and former President Lula da Silva could create space for another candidate to mount a competitive run.
Brazil’s Credit Strengths: Anchored Inflation Expectations, Well-Capitalized Banks, And Solid External Accounts
The central bank is withdrawing monetary policy accommodation amid a surge in inflation. Annual headline inflation reached 9.0% in July, which is well above the upper limit of the central bank’s target range (5.25%) for the year. While the inflationary pressure is broad-based, the most significant contributors have been rising food and energy prices, which have rebounded with recovering global demand. In addition, drought conditions domestically have adversely affected hydroelectricity production, causing electricity prices to rise sharply in recent months. The central bank has responded by raising the policy rate by 325 basis points to 5.25% over the last six months. In DBRS Morningstar’s view, the central bank will likely continue to raise rates over the next six months, ultimately leaving monetary policy in a modestly restrictive stance in order to ensure inflation converges toward its 3.5% target in 2022. This may further constrain growth in the near term.
On an institutional level, the central bank has reinforced its inflation-targeting credibility with the markets over the last five years, as reflected in anchored medium-term inflation expectations. The central bank’s de facto independence was reinforced in February 2021 when the government passed a reform to provide the central bank with greater institutional autonomy. The central bank’s enhanced inflation-targeting credibility, combined with the tapering of directed lending, should strengthen the effectiveness of monetary policy over time.
While the recession hit banks’ profitability, strong capitalization and ample liquidity – supported by the central bank’s liquidity operations – have helped Brazilian banks weather the Covid-19 shock without any major disruption. Strong loan growth, along with higher issuance in the capital markets, supported firms and households through the pandemic, although new loan growth has moderated over the last 6 months as economic conditions have normalized. Regarding asset quality, banks renegotiated loans for clients that were adversely impacted by the virus but were in good standing prior to the shock. The majority of modified loans have resumed repayment as grace periods have expired. Banks appear sufficiently capitalized to digest greater-than-expected credit losses, if necessary, particularly the larger banks with well-diversified loan portfolios. In addition, banks’ direct exposure to exchange rate risk is minimal, and secondary effects on asset quality appear contained.
On the external front, Brazil weathered the shock relatively well, due in part to its flexible exchange rate and sound external position. 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 2020. However, Brazil’s flexible exchange rate helped facilitate an orderly adjustment. The current account deficit narrowed from 3.5% of GDP in 2019 to 1.7% in 2020, as imports were compressed and exports held up relatively well. Net FDI inflows fully financed the current account deficit in 2020, and portfolio flows recovered in the second half of the year. Overall, DBRS Morningstar expects Brazil to run modest current account deficits in the near term, which will be easily financed. Public and private external debt is at a moderate level, thereby reducing risks to balance sheets across the economy related to currency fluctuations. In addition, sizable reserves (23% 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.
Human Capital & Human Rights (S), Bribery, Corruption & Political Risks (G), and Institutional Strength, Governance, and Transparency (G) were among key drivers behind this rating action. Similar to other emerging market economies and many of its regional peers, Brazil’s per capita GDP is low at US$6.8k (US$14.9k on a PPP basis). According to Worldwide Governance Indicators, Brazil ranks in the 47th percentile for Rule of Law and 42rd percentile for Control of Corruption. In addition, Brazil ranks in the 43rd percentile for Government Effectiveness and 48th percentile for Regulatory Quality.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 can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/384031.
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.
All figures are in US 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.
The principal methodology is the Global Methodology for Rating Sovereign Governments https://www.dbrsmorningstar.com/research/381451/global-methodology-for-rating-sovereign-governments (July 9, 2021). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstarcriteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).
Generally, the conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are monitored.
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.
For more information on this credit or on this industry, visit www.dbrsmorningstar.com.
140 Broadway, 43rd Floor
New York, NY 10005 USA
Tel. +1 312 696-6293