DBRS Morningstar Confirms Brazil at BB (low), Stable Trend

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 DBRS Morningstar’s assumption that the next administration will continue to implement a gradual fiscal adjustment, which should help put public finances on a more sustainable path and support macroeconomic stability, but that the economy will remain vulnerable to shocks due to high public debt and weak economic growth. 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.

Brazil is scheduled to hold general elections on October 2, 2022. While uncertainty in the lead up to the election could generate market volatility, we do not expect the next administration – regardless of who wins the presidency – to substantially change the broad orientation of Brazil’s macroeconomic policies. In DBRS Morningstar’s view, the next president is unlikely have a majority in Congress, so the incoming administration will need to build a coalition across a fragmented and centrist legislature in order to pass reforms.

The evolution of the ratings could depend on the willingness and ability of the next administration to sustain fiscal consolidation efforts. The government implemented a massive fiscal adjustment in 2021, when pandemic-related spending was wound down and tax collection benefited from the economic recovery. Fiscal results continued to improve in the first half of 2022 on the back of strong revenue growth. However, recent tax cuts and spending increases cloud the fiscal outlook. Moreover, there is strong political and social pressure for more spending. In this context, we think the next administration will likely amend the spending cap or replace it with a new framework in order to ease the fiscal constraint and accommodate the administration’s priorities. In such a scenario, we would assess the impact on Brazil’s credit profile by looking at the credibility of the new or amended framework in terms of ensuring fiscal sustainability over the medium term. If the next administration does not implement a credible fiscal consolidation plan, the debt ratio would continue on an upward trajectory, thereby leaving Brazilian public finances vulnerable to destabilizing shocks.

The Brazilian economy has recovered from the shock of the pandemic and performed surprisingly well in the first half of 2022. Output in the first quarter of 2022 was 1.6% above the pre-pandemic level (fourth quarter of 2019) and just slightly below output based on pre-pandemic trend growth. High frequency indicators indicate that growth momentum continued into the second quarter. However, we expect the pace of growth to slow in the second half of 2022 and in 2023, as external demand moderates, high inflation erodes consumers’ purchasing power, and the full impact of tight monetary policy is transmitted to the real economy. The IMF forecasts GDP growth of 1.7% in 2022 (which implies approximately no growth in the second half of the year given the carryover) and 1.1% in 2023.

RATING DRIVERS

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. Implementation of 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.

RATING RATIONALE

The Election Generates Political Uncertainty But Is Unlikely To Materially Change Brazil’s Macroeconomic Policy Orientation

Brazil is scheduled to hold general elections on October 2, 2022. If no presidential candidate receives 50% of the valid votes, a second round will be held on October 30, 2022. Recent polls show former president Luiz Inácio Lula da Silva leading President Jair Bolsonaro by a sizable margin. However, the race could narrow, especially since the government recently cut fuel taxes and increased social spending. The likelihood of a third candidate challenging the two frontrunners at this point appears low. So far, Lula and Bolsonaro have been vague about their specific policy proposals, but both campaigns have generally focused on issues such as social spending and the expenditure cap, tax reform, and labor regulations. Regardless of who wins the presidency, DBRS Morningstar does not expect material changes in the broad orientation of Brazil’s macroeconomic policies. The next president is unlikely to have a majority in Congress, so the incoming administration will need to build a coalition across a fragmented and centrist legislature in order to pass reforms.

The Most Important Policy Issue Facing Brazil’s Sovereign Credit Profile Is Consolidating Fiscal Accounts

Fiscal results continued to improve in the first half of 2022, but recent tax cuts and spending increases cloud the outlook for fiscal sustainability. Brazil implemented a massive fiscal adjustment in 2021, when pandemic-related spending was unwound and tax collection benefited from the recovery. The consolidated public sector primary balance shifted from a deficit of 9.4% of GDP in 2020 to a surplus of 0.7% in 2021. Fiscal results continued to improve in the first half of 2022 on the back of strong revenue growth. Several factors drove the increase in revenue, including better-than-expected economic growth, elevated commodity prices, and high inflation. In May, the 12-month consolidated public sector posted a primary surplus of 1.3% of GDP. The fiscal result is the best in 8 years. However, fiscal accounts are likely to deteriorate in the second half of 2022. The government recently cut federal taxes on fuels through the end of the year, passed a constitutional amendment to temporarily expand social benefits and deliver aid to truckers and taxi drivers, and passed a law that cut state-level tax rates on essential goods and services. According to the August 1st FOCUS Survey, median expectations point to a primary surplus of 0.3% for the year.

Notwithstanding the improving fiscal results through mid-year, the combination of permanent tax cuts and higher spending in the context of rising uncertainty about the fiscal framework raise concerns about fiscal outlook. Commodity-related revenue gains may prove transitory, the state-level sales tax cut is permanent, and both presidential candidates have expressed their intention to permanently expand social benefits under Auxilio Brazil. The structural deterioration associated with these measures will increase the scale of the fiscal adjustment necessary to stabilize public debt dynamics. Taking into account the full-year effect of recent measures, median expectations according to the FOCUS Survey point to a primary deficit of 0.3% for 2023.

In the context of rising political and social pressure for more spending, we expect the next administration – regardless of who wins the presidency – to amend the spending cap or replace it with a new framework in order to ease the fiscal constraint and accommodate the administration’s priorities. In such a scenario, we will be looking at the credibility of the new or amended framework in terms of ensuring fiscal sustainability over the medium term.

The pandemic-induced recession and fiscal response have pushed public debt levels higher, although by less than previously expected. Gross non-financial public sector debt (IMF definition) jumped from 88% of GDP in 2019 to 99% in 2020. With relatively low interest rates, strong growth and better fiscal results, the debt ratio declined to an estimated 93% in 2021. The IMF projects the ratio to fall to 92% in 2022. This is nearly 6 percentage points of GDP lower than we projected in our last review in September 2021. Going forward, however, the trajectory is upward and roughly the same as projected one year ago. Assuming that the primary deficit shifts to a balanced position in 2024 and then reaches a surplus of 1.0% of GDP in 2027, the debt-to-GDP ratio would gradually rise through 2026 when it would peak at 95%. This scenario does not include potential extraordinary receipts, such as privatization proceeds, nor the potential drawdown of the government’s sizable liquid assets, both of which could reduce the gross debt ratio. In addition, almost all public debt is denominated in local currency and held by Brazilian residents, thereby reducing exchange rate and rollover risks stemming from global market volatility.

Nevertheless, DBRS Morningstar considers debt sustainability risks to be elevated. 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. Tighter financing conditions or rising risk premiums could also worsen debt dynamics. The vulnerability of public finances to shocks highlights the importance of pursuing a consolidation strategy backed by a credible fiscal framework that reinforces market confidence and sustains access to affordable borrowing.

Brazil’s Medium-Term Growth Prospects Are Relatively Weak

The IMF estimates potential GDP growth at around 2 percent. The poor outlook partly reflects Brazil’s aging population, which has led to a slowdown in the growth of the labor force. 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. In DBRS Morningstar’s view, the election results in October are not likely to have a material impact (positive or negative) on Brazil’s growth prospects. 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.

We view the risks around the growth outlook as balanced. The cumulative impact of recently implemented microeconomic reforms related to credit markets, labor regulations, and infrastructure concessions could strengthen investment and productivity more than currently expected. Alternatively, a political unwillingness or inability to address macroeconomic imbalances could end up dampening investment and weakening growth prospects.

Brazil’s Credit Strengths: Solid Monetary Policy Framework, Well-Capitalized Banks, And Healthy External Accounts

The central bank has responded to surging inflation by aggressively tightening monetary policy. Annual headline inflation reached 12.1% in April before declining slightly to 11.9% in June. This is well above the upper limit of the central bank’s target range of 5.0% for the year. Rising food and energy prices have contributed to inflationary pressures, but the price gains are broad-based. In response, the central bank raised the policy rate from 2.0% in March 2021 to 13.25% in June 2022. Such actions have put monetary policy in a highly restrictive stance. The real policy rate was 7.0% in June, against the central bank’s estimate of the neutral real rate of 4.0%. We expect inflation to decline in the second half of 2022, partly due to federal and state tax cuts on fuels, electricity, and telecommunications. Median expectations for yearend inflation, according to the August 1st FOCUS Survey, are 7.2%. However, the disinflationary process could be slow. According to the FOCUS survey, inflation will only decline to 5.3% by the end of 2023, which is still above the upper limit of the central bank’s target range (4.75%) for 2023. Against this backdrop, the central bank looks set to maintain a highly restrictive policy stance through 2023, which will likely act as a headwind to growth in the near term.

On an institutional level, the central bank has reinforced its inflation-targeting credibility with the markets over the last six years. 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. Moreover, the central bank’s enhanced inflation-targeting credibility, combined with the tapering of directed lending, should strengthen monetary policy transmission over time.

Brazil’s large banks remain highly capitalized with ample liquidity, but challenging market conditions could weigh on profitability. Higher levels of debt, combined with rising interest rates and high inflation, could make it more difficult for some households to make their debt repayments. Non-performing loans among households increased in the second half of 2021 and in early 2022. However, the overall level of non-performing loans remains low, and banks appear well-provisioned and sufficiently capitalized to digest greater-than-expected credit losses, if necessary, particularly the larger banks with well-diversified loan portfolios. In addition, banks appear well-positioned to manage global market volatility. Their reliance on external funding is low and their direct exposure to exchange rate risk is minimal.

Brazil’s External Accounts Are In A Relatively Strong Position

The current account posted a deficit of 1.4% of GDP (rolling 4 quarters) in the first quarter of 2022. Rising global commodity prices due to the implications of Russia’s invasion of Ukraine have not had a major impact on Brazil’s terms of trade. Primary goods exports, such as soybeans and meat, have benefited from higher prices, but the positive price effect has been offset by a widespread increase in import prices, particularly fertilizers. We expect the current account to remain in a modest deficit position over the next few years, with net FDI inflows providing a stable source of external financing. Brazil’s flexible exchange rate should help external accounts adjust to evolving global conditions. Moderate external debt levels reduce risks to balance sheets across the economy stemming from potential currency fluctuations. In addition, sizable foreign exchange reserves (21% of GDP) provide the central bank with substantial resources to mitigate the impact of potential capital flow volatility, if necessary.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Environmental (E) Factors
This factor is relevant but does not affect the ratings. Under the 2015 Paris Agreement, Brazil seeks to reduce its greenhouse gas (GHG) emissions by 50% by 2030 from 2005 levels. Brazil’s ability to meet its Paris commitments appears achievable but may depend on implementing policies that reduce agriculture-related emissions (particularly from livestock production), incentivize further investment in renewable energy (Brazil already generates a comparatively high share of energy from renewables), and curb deforestation in the Amazon. Land management practices in Brazil could create economic challenges and strain trading relationships over time and, as a result, the factor Land Impact and Biodiversity is a relevant factor for the ratings. On the other hand, the fiscal, regulatory, and enforcement measures required to achieve the country’s climate goals are unlikely to impact sovereign credit quality.

Social (S) Factors
The Human Capital & Human Rights factor affects the ratings. Similar to other emerging market economies and many of its regional peers, Brazil’s per capita GDP is low at US$7.6k (US$16.2k on a PPP basis). This reflects a relatively low level of labor productivity. The factor Access to Basic Services does not affect the ratings. Brazil has universal healthcare coverage, although the quality can vary significantly across the country.

Governance (G) Factors
Two governance factors affect the ratings: (1) Bribery, Corruption and Political Risk, and (2) Institutional Strength, Governance and Transparency. According to Worldwide Governance Indicators, Brazil ranks in the 48th percentile for Rule of Law and 43rd percentile for Control of Corruption. In addition, Brazil ranks in the 36th percentile for Government Effectiveness and 46th percentile for Regulatory Quality. The third factor, Peace and Security, does not affect the ratings, although Brazil exhibits some signs of social strife and challenges relating to violence in major cities.

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/401029.

Notes:
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 Eletrobras.

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 DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022).

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, International Monetary Fund, 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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