DBRS Confirms Brazil at BB (low), Stable Trend

DBRS, Inc. confirmed Brazil’s Long-Term Foreign and Local Currency – Issuer Ratings at BB (low) and its Short-Term Foreign and Local Currency – Issuer Ratings at R-4. The trend on all ratings remains Stable.

KEY RATING CONSIDERATIONS

Prospects for policy action to address the fiscal imbalance and increase potential growth are unclear ahead of general elections next month. The most pressing issue facing Brazil’s credit profile is the large budget deficit and rising public debt burden. The constitutional spending cap creates strong incentives to follow through with fiscal consolidation. However, it is unclear whether the next administration will have the willingness and ability to build a congressional coalition large enough to pass the necessary structural reforms. Without corrective policy action, concerns about public debt sustainability will intensify. General elections are scheduled for October 7th. If no presidential candidate receives 50% of the vote, which seems highly likely in this election, a second round of voting among the top two finishers will take place on October 28th.

The Stable trend indicates that upside and downside risks to the ratings are balanced. Recent positive developments, such as improved monetary policy credibility, reformed credit markets and stronger household balance sheets, put the economy in a better position to grow. Nonetheless, prospects for a sustained recovery depend on the implementation of a credible deficit-reduction plan by the next administration.

RATING DRIVERS

The ratings could experience upward pressure if the next government implements a fiscal consolidation plan, underpinned by a reform that stems the growth of pension spending. The structural nature of such an adjustment would lend credibility to the plan, which could strengthen confidence, lower real interest rates and accelerate the recovery. Economic reforms that improve the investment outlook and facilitate deeper integration into global markets would also be credit positive.

On the other hand, the ratings could experience downward pressure if the next administration does not pass reforms to curb the spending trajectory and address Brazil’s structural fiscal imbalance. External shocks that exacerbate Brazil’s growth challenges could make the necessary fiscal adjustment even more difficult to achieve.

RATING RATIONALE

Prospects For Policy Action Are Uncertain In The Post-Election Environment

Brazil’s electoral outlook remains highly uncertain. With less than four weeks remaining until the first-round vote, there are still five viable presidential candidates in the race. Former president Luiz Inácio Lula da Silva of the Workers’ Party (PT), who is barred from running, aims to transfer his popularity to the PT candidate, Fernando Haddad. The PSDB candidate, Geraldo Alckmin, is trying to capitalize on his institutional advantages, such as greater television time and nationwide party machinery. On the other hand, widespread dissatisfaction with the political elite creates space for smaller-party candidates, such as Marina Silva, or anti-establishment candidates, such as Jair Bolsonaro, to win a place in the second round.

Most of the candidates recognize the need for spending reform. However, even if the next president wants to pursue budget consolidation, it is unclear whether the next administration will be able to build a congressional coalition large enough to pass key legislation, particularly pension reform which requires amending the constitution. The challenge could be even greater if the next president’s party has limited representation in congress.

On an institutional level, the Car Wash investigations have revealed widespread corruption but also highlighted some of Brazil’s strengths. According to the World Bank Governance Indicators, Brazil compares poorly to many other emerging economies in the area of corruption control. However, Brazil’s institutional response to corruption in recent years is encouraging. The investigations themselves are the product of a strong and independent judiciary, which has been supported by an active civil society and vibrant media. One legacy of the Car Wash probe could be better corporate governance.

Fiscal Dynamics Are Unsustainable Without Corrective Action

The most pressing issue facing Brazil’s credit profile is the fiscal deficit. The consolidated primary balance deteriorated from a surplus of 2.9% of GDP in 2011 to a deficit of 2.5% in 2016. The Temer administration responded by implementing an expenditure-based fiscal consolidation plan, which is underpinned by a constitutional amendment that limits the growth of primary spending to the rate of inflation. Compliance with this spending cap was achieved in 2017, and the primary deficit narrowed to 1.7% of GDP. Spending will likely come in below the cap in 2018 as well, driven by large cuts in discretionary expenditure. However, the improving headline figure masks an unfavorable structural outlook. Given the high share of spending that is constitutionally protected or indexed to the minimum wage, pressures on mandatory expenditure continue to build. In particular, the scale and growth of pension spending makes reform essential.

In the absence of reform, mandatory expenditure will likely exceed the spending cap starting in 2020. This leaves the next administration with a short period of time to act. If the spending cap is breached, automatic austerity measures will be triggered, forcing a fiscal adjustment that would be both economically inefficient and politically challenging.

Public debt dynamics are not expected to stabilize in the near term. Assuming future governments comply with the spending cap, DBRS estimates that the primary balance would shift to a surplus in 2022 and then rise to 2.2% of GDP in 2026. In such a scenario, gross non-financial public sector debt (based on IMF definition) would peak in 2024 at around 96% of GDP and then gradually decline. Stronger growth on the back of corrective policy action and economic reforms could also materially improve debt sustainability. On the other hand, if spending reforms are not passed, public debt ratios would continue to rise, thereby jeopardizing the sustainability of public finances and, potentially, macroeconomic stability.

Medium-Term Growth Prospects Are Weak

The cyclical recovery continues to advance but Brazil’s medium-term growth prospects are weak. The IMF projects that Brazil will expand on average 2.2% per year from 2020-2023, below most emerging market peers. The poor outlook partly reflects demographics, but 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, which holds back productivity. In addition, high tariff barriers, elevated compliance costs, and inward-looking policy impede Brazil from more fully benefiting from global trade.

The Temer administration has taken some measures to improve the investment climate. In July 2017, congress passed labor reform, which should make the jobs market more flexible and encourage greater formalization. In September 2017, congress passed a law that gradually aligns directed lending rates with market rates. This should improve credit allocation and enhance budget transparency. In addition, the government eased restrictions in the oil and gas sector and scaled back local content rules, making the sector more attractive to foreign capital. Nevertheless, the implementation of a broader structural reform agenda that strengthens Brazil’s medium-term growth outlook will depend on the next government.

Inflation Expectations Are Anchored, The Banking System Is Healthy, And External Accounts Are Sound

Prudent monetary policy has consolidated inflation at low levels and anchored inflation expectations around the target. Although the truckers’ strike in May 2018 resulted in a temporary price shock, the inflation outlook remains relatively benign with risks both to the upside and downside. In July 2018, year-over-year inflation was 4.5%, which is in line with the target for the year. The central bank is implementing expansionary monetary policy, in the context of a large negative output gap, in order to support the economic recovery. Enhanced central bank credibility combined with the tapering of directed lending should strengthen the effectiveness of monetary policy over time.

The banking system has weathered the recession well. Banks remain profitable and well-capitalized, even considering the Basel III requirements. Asset quality is benefiting from the recovery. The delinquency rate (loans 90 days past due) for household and corporate loans declined from 4.0% in May 2017 to 3.0% in July 2018. Moreover, in the event of macroeconomic shocks, the banking system appears sufficiently capitalized to digest additional credit losses or manage unexpected financial market volatility, including large swings in the exchange rate, without major disruption.

Brazil’s external accounts do not exhibit any significant imbalances. Gross external liabilities are moderate, the current account deficit is modest, and inflows of net foreign direct investment provide a stable source of external financing. Moreover, exchange rate flexibility facilitates Brazil’s adjustment to global conditions. In the event of an external shock, the central bank has a large stock of reserves to provide foreign exchange liquidity if necessary.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the BB (high) – BB (low) range. The main points discussed during the Rating Committee include the electoral outlook, prospects for advancing the reform agenda, and the economy’s performance in 2018.

KEY INDICATORS

Fiscal Balance (% GDP): -7.9 (2017); -8.5 (2018F); -7.8 (2019F)
Gross Debt (% GDP): 84.0 (2017); 88.2 (2018F); 90.4 (2019F)
Nominal GDP (USD billions): 2,055 (2017); 2,088 (2018F); 2,198 (2019F)
GDP per capita (USD thousands): 9.9 (2017); 10.0 (2018F); 10.4 (2019F)
Real GDP growth (%): 1.0 (2017); 1.8 (2018F); 2.5 (2019F)
Consumer Price Inflation (%, eop): 2.9 (2017); 3.5 (2018F); 4.1 (2019F)
Domestic Credit (% GDP): 47.1 (2017); 46.8 (June-2018)
Current Account (% GDP): -0.5 (2017); -1.6 (2018F); -1.8 (2019F)
International Investment Position (% GDP): -32.5 (2017); -25.1 (June-2018)
Gross External Debt (% GDP): 32.5 (2017); 32.5 (June-2018)
Foreign Exchange Reserves (% short-term external debt + current account deficit): 274.9 (2017); 283.6 (June-2018)
Governance Indicator (percentile rank): 53.7 (2016)
Human Development Index: 0.75 (2015)

Notes:

All figures are in U.S. dollars unless otherwise noted. 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. Domestic Credit refers to domestic bank credit. Gross External Debt includes inter-company loans and fixed income securities traded in the domestic market held by non-residents. Short-Term External Debt is measured on a residual maturity basis. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The 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, WTO, Total Economy Database – Conference Board, Tullet Prebon Information, JPMorgan, FUNCEX, NRGI, Brookings, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be 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 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.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Michael Heydt, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer – Global FIG and Sovereign Ratings
Initial Rating Date: 6 July 2006
Last Rating Date: 16 March 2018

Information regarding DBRS ratings, including definitions, policies and methodologies, is available on www.dbrs.com.