Morningstar DBRS Confirms Brazil at BB, Stable Trend

DBRS, Inc. (Morningstar DBRS) confirmed the Federative Republic of Brazil's Long-Term Foreign and Local Currency - Issuer Ratings at BB. At the same time, Morningstar DBRS 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 Stable trend balances Brazil's solid economic and labor market outlook with long-standing fiscal challenges. Growth is moderating from an above-trend pace last year due to a restrictive monetary policy, a slightly tighter fiscal stance, and a normalization in agricultural output following a record harvest in 2023. Supply disruptions caused by the flooding in Rio Grande do Sul in the second quarter appear temporary and limited. The labor market continues to perform well, with a low unemployment rate, increasing formality, and strong real wage growth. Price pressures have eased and core inflation is now running close to the three percent target. In addition, the current account deficit is modest and largely financed by net FDI inflows. Overall, the economy is well-balanced, with the IMF projecting GDP growth of 2.1% in 2024 and 2.4% in 2025. However, the fiscal outlook is a source of vulnerability. We expect some fiscal tightening in 2024, but achieving the primary balance target looks difficult given the strong pace of expenditure growth in the first half of the year.

The BB credit ratings are supported by the country's flexible exchange rate, sound financial system, and strong external position. These factors enhance the resilience of the Brazilian economy. The key challenge for the credit rating is putting public finances on a sustainable path. General government debt (IMF definition) is expected to increase to 87% of GDP this year. While a new fiscal framework sets out a gradual deficit-reduction path, the debt-to-GDP ratio, according to IMF projections, is not expected to stabilize over the next five years. 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.

CREDIT RATING DRIVERS
The credit 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 credit 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
High and Rising Public Debt Leave Public Finances Vulnerable to Shocks

Consolidating fiscal accounts continues to present the most significant challenge to sovereign credit profile. After posting a primary deficit of 2.4% of GDP in 2023, the central government is targeting a primary balance for 2024 (plus or minus 0.25% of GDP excluding one-off expenses). Part of the adjustment should come from not repeating last year's payment of delayed judicial remedies (0.9% of GDP); the rest of the adjustment relies on revenue-raising measures and tight expenditure control. In the first five months of 2024, revenue increased at a strong clip (9% year-over-year in real terms). Primary expenditures rose even faster (13%), largely due to strong growth in mandatory spending. However, we expect expenditure growth to moderate in the second half of the year for two reasons. First, part of the expenditure growth through May reflects timing issues (e.g. the delayed minimum wage adjustment in 2023). These issues should unwind as the year progresses. Second, the Lula administration recently announced a spending freeze on certain budgetary items. Although we expect expenditure growth will moderate through the remainder of the year, we are not confident that the government will achieve the primary balance target. According to the July 19th FOCUS survey, the median expectation for the primary deficit of the public sector (which includes central, state, and local governments as well as social security funds) is 0.7% of GDP in 2024.

Compliance with the fiscal rules post-2024 looks even more challenging in the absence of spending reforms. Growth in mandatory spending, most of which is indexed to revenue or the minimum wage, is forcing the government to increasingly squeeze discretionary spending. Without reform, this dynamic runs the risk of being incompatible with the spending rule over time. In addition, resistance by Congress to tax increases could complicate the government's revenue-based consolidation strategy. Earlier this year, the government presented to congress a move to lower the 2025 primary surplus target from 0.5% to 0.0% and the 2026 target from 1.0% to 0.25%. Even with the revision, the projected consolidation path looks challenging. Nevertheless, we think ongoing efforts to comply with the fiscal rules reduce downside risks to the outlook and account for the one-category uplift to the Fiscal Management and Policy building block.

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. Assuming the government reaches a primary surplus of 0.25% of GDP in 2026, as outlined in the 2025 Budget Guidelines Bill, we estimate that the next administration would need to tighten fiscal policy by about 1.0-1.5% of GDP in order to put public finances on a sustainable path. Tighter financing conditions or rising risk premiums could also worsen debt dynamics, especially as nearly 44% of the debt is floating rate and the average maturity is relatively short (4.1 years). The vulnerability of public finances to shocks highlights the importance of pursuing a credible consolidation strategy.

The Lula Administration Is Constrained By A Powerful Congress

President Luiz Inácio Lula da Silva's ability to advance his legislative agenda is constrained by a right-of-center and increasingly assertive Congress. There were areas of executive-legislative cooperation in 2023, including passage of the new fiscal framework and the VAT tax reform, but bridging the ideological differences between the President and Congress has become more difficult this year, especially with local elections approaching in October 2024. The current political landscape will constrain bold left-of-center or right-of-center reform efforts and advancing legislation will likely require compromise. Finding consensus around the fiscal adjustment has proven difficult. President Lula has been reluctant to cut spending or press for politically-sensitive spending reforms (e.g. delinking minimum pensions from the minimum wage). At the same time, Congress has resisted some efforts by the Lula administration to raise revenue. Overall, we expect modest and incremental progress on the fiscal front, with more politically sensitive legislation set aside until after local elections.

Brazil's Medium-Term Growth Prospects Are Modest But A Series of Reforms Present Upside Risk To The Outlook

Brazil's subdued growth outlook partly reflects the country's aging population, which has led to a slowdown in the growth of the labor force. 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 modest medium-term growth outlook has led us to make a negative adjustment in the "Economic Structure and Performance" building block assessment.

However, the microeconomic reforms implemented over the last eight years could have a positive impact on investment and productivity. Past reforms include changes to credit markets, labor regulations, infrastructure concessions, and the value-added tax. The latter, 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. We view the balance of risks as symmetrical. On the upside, the positive impact of the reforms on growth could be greater than anticipated. On the downside, the unwillingness or inability of policymakers to address fiscal imbalances could end up dampening investment and weakening growth.

Brazil's external accounts are in a relatively strong position. In the 12 months to June 2024, the current account posted a deficit of 1.4% of GDP. 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 (16% of GDP) provide the central bank with substantial resources to mitigate the impact of potential capital flow volatility, if necessary. Taken together, Brazil's solid external position and capacity to adjust to shocks has led us to make a positive adjustment in the "Balance of Payments" building block assessment.

Brazil's Solid Monetary Policy Framework And A Well-Capitalized Banking System Bolster Economic Resilience

Twelve-month headline and core inflation metrics largely trended within the upper bound of the tolerance interval (+/- 1.5 percentage point) around the 3% target during the first half of 2024. Headline inflation was 4.2% in June. However, further progress on returning to point target of 3% may be slow due to 1) tightness in the labor market, which could moderate the pace of disinflation in service sectors, 2) more adverse global and domestic factors (i.e. uncertainty about timing and pace of monetary easing in the United States and fiscal uncertainty domestically), and 3) the flooding in Rio Grande do Sul, which could push up food prices. According to the July 19th FOCUS Survey, expectations for yearend inflation in 2024 and 2025, recently inched up to 4.1% and 3.9%, respectively. The central bank paused the easing cycle at its June meeting. This came after seven consecutive cuts (six 50bps cuts and one 25bps cut) which lowered the policy rate from 13.75% to 10.5%. The pause leaves the real policy rate (ex-ante) around 6.75% in June, which is 300bps lower than peak tightness one year ago but above the central bank's estimate of the neutral real rate of 4.75%. We think the central bank may restart the easing cycle within the next 12 months if inflation risks dissipate and inflation expectations shift back toward the target.

Brazil's large banks are well capitalized and have ample liquidity. Credit growth picked up slightly in the first half of the year, after a pronounced slowdown in 2023. The share of non-performing loans has stabilized at moderate levels, with asset quality benefitting from declining borrowing rates and a robust labor market. However, households' debt service-to-income ratio remains historically high. 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.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

ESG Considerations had a significant effect on the credit analysis.

Environmental (E) Factors
The following Environmental factor had a relevant effect on the credit analysis: Land Impact and Biodiversity. Land management practices in Brazil could create economic challenges and strain trading relationships over time. This has been taken into account within the "Economic Structure and Performance" building block.

Social (S) Factors
The following Social factor had a significant effect on the credit analysis: Human Capital & Human Rights. Similar to other emerging market economies and many of its regional peers, Brazil's per capita GDP is low at US$10.6k (US$20.0k 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
The following Governance factors had a significant effect on the credit analysis: (1) Bribery, Corruption and Political Risks, and (2) Institutional Strength, Governance and Transparency. According to Worldwide Governance Indicators, Brazil ranks in the 43rd percentile for Rule of Law and 32nd percentile for Control of Corruption. In addition, Brazil ranks in the 30th 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 Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (23 January 2024) https://dbrs.morningstar.com/research/427030

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/436847.

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.

The principal methodology is the Global Methodology for Rating Sovereign Governments (15 July 2024) https://dbrs.morningstar.com/research/436000. In addition, Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://dbrs.morningstar.com/research/427030 in its consideration of ESG factors.

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

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS' outlooks and credit ratings are monitored.

The primary sources of information used for these credit ratings include the 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. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings 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.

Morningstar DBRS 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.

For more information on this credit or on this industry, visit dbrs.morningstar.com.

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