DBRS Morningstar Upgrades Brazil to BB, Stable Trend

DBRS Inc. (DBRS Morningstar) upgraded the Federative Republic of Brazil’s Long-Term Foreign and Local Currency – Issuer Ratings to BB from 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 CREDIT RATING CONSIDERATIONS

The upgrade to BB primarily reflects diminishing downside risks to the fiscal outlook. Due to a package of revenue-raising measures earlier this year, the primary deficit is expected to come in around 1.0% of GDP, an improvement from the projected deficit of 2.3% in the 2023 budget. The government is also putting in place a new fiscal framework that targets a primary balance in 2024 and a surplus of 1.0% of GDP in 2026. We expect congress will approve the framework in August 2023. In our view, even if the primary targets are not achieved, the new framework signals that fiscal results will continue to improve during the Lula administration. Improvements in DBRS Morningstar’s “Fiscal Management and Policy” and “Debt and Liquidity” building blocks are the key factors contributing to the upgrade.

Although Brazil’s weak medium-term growth prospects remain a key credit challenge, we also view the cumulative impact of economic reforms implemented over the last two administrations as credit positive. Reforms to the credit markets, labor regulations, and infrastructure concessions could end up boosting investment and productivity more than currently expected. The value-added tax reform, which the lower house recently passed and is now under consideration in the Senate, could also improve growth prospects over time. In addition, the central bank’s inflation-targeting credibility has been strengthened on the back of institutional changes and a solid track record.

Notwithstanding these positive developments, Brazil continues to face significant credit challenges. In particular, high public debt, a large fiscal deficit, and modest growth prospects leave the economy vulnerable to shocks. The new fiscal framework sets out a deficit-reduction path through 2026, but even if the targets are achieved the resulting consolidation may not be sufficient to stabilize debt dynamics. Absent further adjustment, the debt ratio could continue on an upward trajectory and jeopardize the sustainability of public finances.

CREDIT RATING DRIVERS

The ratings could be upgraded if the government advances a structural fiscal adjustment that improves public debt dynamics. 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.

CREDIT RATING RATIONALE

Risks to the Fiscal Outlook Have Declined, But High and Rising Public Debt Leave Public Finances Vulnerable to Shocks

Two actions have reduced downside risks the fiscal outlook. First, the Lula administration implemented a series of measures early in the year to curb the fiscal deficit. After posting a primary surplus of 1.3% of GDP (consolidated public sector) in 2022, fiscal accounts were set to deteriorate sharply in 2023 on account of tax cuts and a large expansion of social benefits. The 2023 budget estimated a primary deficit of 2.3% of GDP. However, revenue-raising actions in early 2023 have improved the outlook. According to the July 21st FOCUS survey, the median expectation for the public sector primary deficit is 1.0% of GDP.

Second, the government is putting in place a new framework that will act as a constraint on fiscal policy going forward. The framework targets a primary balance in 2024 and a surplus of 1.0% of GDP in 2026. It also limits primary expenditure growth to 70% of revenue growth. The deficit-reduction measures in 2023 combined with the new framework reduce downside risks to the fiscal outlook and account for the one-category uplift to the Fiscal Management and Policy building block.

Brazil’s government debt levels are high but lower than previously projected. Due to the pandemic and associated policy response, gross non-financial public sector debt (IMF definition) jumped from 88% of GDP in 2019 to 97% in 2020. However, Brazil’s strong recovery and rapid fiscal repair drove the debt ratio down to 86% in 2022. This places the debt ratio not only 2 percentage points of GDP lower than before the pandemic, it is 6 percentage points lower than projected in our August 2022 review and 13 percentage points lower than projected in our September 2021 review.

Notwithstanding these positive developments, consolidating fiscal accounts continues to present the most significant challenge to sovereign credit profile. Meeting the new primary balance targets will require substantially more revenue and strict expenditure control. The government plans to raise revenue, in part, by introducing income tax reform later this year, which in our view, will be difficult to pass in congress. Controlling expenditures is also complicated by spending items that are indexed to revenue or the minimum wage. Given the myriad challenges, we are not confident that the primary targets will be met; nevertheless, we assume that the constraints built in to the new framework will keep fiscal accounts on a gradually improving path. Another challenge is that even if the targets established in the new framework are achieved, they are unlikely to stabilize debt dynamics during the Lula administration. Assuming the government reaches a primary surplus of 1.0% of GDP in 2026, as outlined by the new framework, we estimate that the next administration would need to tighten fiscal policy by about 1% of GDP in order to put public finances on a sustainable path.

The composition of Brazil’s public debt provides some advantages, but the high level of debt and stressed fiscal accounts leave public finances vulnerable to shocks. Almost all government debt is denominated in local currency and held by Brazilian residents. This, combined with the Treasury’s sizable liquid holdings, reduce exchange rate and rollover risks. However, the debt ratio will continue to rise if fiscal consolidation efforts are not sustained. Tighter financing conditions or rising risk premiums could also worsen debt dynamics, especially as nearly 40% of the debt is floating rate and the average maturity is relatively short (4.0 years). 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 Solid Monetary Policy Framework and a Well-Capitalized Banking System Have Helped the Economy Weather Shocks

On an institutional level, the central bank has reinforced its inflation-targeting credibility with the markets over the last 7 years. From 2016 to 2020, policy actions backed by clear objectives and enhanced communication better anchored inflation expectations around the target. Global shocks have recently lifted inflation above the target, but policymakers have acted to reinforce the central bank’s inflation-fighting credentials. The government passed a reform in February 2021 to provide the central bank with greater institutional autonomy. In addition, Brazil’s National Monetary Council decided in June 2023 to set the inflation target rate at 3% from 2024 onwards, thereby helping anchor medium-term expectations.

The inflation outlook is clearly improving. Annual headline inflation declined from its peak of 12.1% in April 2022 to 3.2% in June 2023. Driving disinflation is moderating food prices and easing supply shocks. Year-over-year inflation will likely increase in the second half of this year as the base effects from the tax cuts on fuel last summer drop out of the calculation. Core inflation is also cooling but still above levels consistent with the central bank’s targets. Expectations for yearend inflation in 2023 and 2024, according to the July 21st FOCUS Survey, are 4.9% and 3.9%, respectively. In response, the central bank has kept the policy rate at 13.75% since August 2022, thereby putting monetary policy in a highly restrictive stance. The ex-ante real policy rate was above 9% in June 2023, against the central bank’s estimate of the neutral real rate of 4.5%. The central bank looks set to start lowering the policy rate in the next 1-2 months. However, with core inflation running a bit hot and inflation expectations still hovering slightly above target, rate cuts will likely be conducted in a gradual manner with the overall policy stance remaining restrictive through 2024.

Brazil’s large banks remain highly capitalized with ample liquidity, but challenging market conditions weigh on profitability. Higher levels of debt combined with rising interest rates are contributing to slower credit growth and making it more difficult for some households and firms to service their debts. Non-performing loans increased to 3.6% in May 2023, the highest level since October 2017. However, early delinquency rates (15-90 days past due) have stabilized in recent months, 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.

Reforms Pose Some Modest Upside Risk to Medium-Term Growth Prospects

The IMF estimates potential GDP growth at around 2 percent. The relatively 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. 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 well-balanced although slightly skewed to the upside. The cumulative impact of microeconomic reforms implemented over the last two administrations could end up boosting investment and productivity more than currently expected. Past reforms include changes to credit markets, labor regulations, and infrastructure concessions. The value-added tax reform, which the lower house recently passed and is now under consideration in the Senate, would also be positive. The reform, which is designed to be revenue-neutral, is unlikely to spur activity in the near term but given the substantial scope for efficiency gains it could have a meaningful impact on growth over time. Alternatively, a political unwillingness or inability to address fiscal imbalances could end up dampening investment and weakening growth prospects.

Brazil’s external accounts are in a relatively strong position. In the 12 months to May 2023, the current account posted a deficit of 2.5% of GDP. Rising global commodity prices due to 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. With regards to volumes, rising agricultural and mining exports are supporting the trade balance. We expect the current account to remain in a moderate 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 (17% of GDP) provide the central bank with substantial resources to mitigate the impact of potential capital flow volatility, if necessary.

The Current Political Landscape Presents Challenges and Opportunities

The capacity of Brazil’s leftist President Luiz Inácio Lula da Silva (Lula) to advance his legislative agenda will depend, in large part, on his ability to build consensus in a congress that is right-of-center and increasingly assertive. We expect congress will likely moderate Lula’s tax and expenditure proposals and resist any potential efforts to reverse previously passed reforms (i.e. labor reform, the privatization of Eletrobras). Nevertheless, there appear to be opportunities for executive-legislative cooperation. This has been evident over the last six months as congress and the Lula administration have worked together to advance a new fiscal framework and value-added tax reform. However, finding consensus on income tax reform, which we expect will be presented in the second half of the this year, could prove to be more difficult.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Environmental (E) Factors
This factor is relevant but does not have a significant effect the ratings. 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. This has been taken into account within the “Economic Structure and Performance” building block.

Social (S) Factors
The Human Capital & Human Rights factor has a significant effect on the ratings. Similar to other emerging market economies and many of its regional peers, Brazil’s per capita GDP is low at US$9.0k (US$17.9k on a PPP basis). This reflects a relatively low level of labor productivity. This factor has been taken into account in the “Economic Structure and Performance” building block.

Governance (G) Factors
Two governance factors have a significant effect the ratings: (1) Bribery, Corruption and Political Risks, and (2) Institutional Strength, Governance and Transparency. According to Worldwide Governance Indicators, Brazil ranks in the 42nd percentile for Rule of Law and 34th percentile for Control of Corruption. In addition, Brazil ranks in the 35th percentile for Government Effectiveness. These factors are taken into account in the “Political Environment” and “Fiscal Management and Policy” building blocks.

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 (July 4, 2023) at https://www.dbrsmorningstar.com/research/416784/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/417834.

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 (August 29, 2022) https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments. In addition DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

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 credit ratings are monitored.

The primary sources of information used for this credit 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 credit rating was of satisfactory quality.

The credit rating was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

DBRS Morningstar did not have access to the accounts, management and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is a solicited credit rating.

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