DBRS Confirms Brazil at BB (low), Stable Trend

DBRS, Inc. (DBRS) confirmed the Federative Republic of Brazil’s Long-Term Foreign and Local Currency – Issuer Ratings at BB (low). At the same time, 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 RATING CONSIDERATIONS

The Brazilian government is pursuing a broad reform agenda to repair fiscal accounts and strengthen the economy’s weak growth outlook. Passage of pension reform in the Lower House marked a major step toward restoring fiscal sustainability. The legislation is now in the Senate, where DBRS expects it will be approved largely in its current form within the next 1-2 months. While the reform reduces risks to the fiscal outlook, additional tightening measures will be needed to put public debt dynamics on a sustainable path.

The economic recovery continues to advance, albeit at an anemic pace. In the near term, DBRS expects the cyclical recovery to gradually accelerate on the back of expansionary monetary policy and strengthening confidence. Prospects for higher medium-term growth, however, depend on structural reforms. In this regard, the government is moving on multiple fronts, with measures to lower the cost of doing business, improve the efficiency of credit markets, and open the economy to international competition.

The Stable trend indicates that upside and downside risks to the BB (low) ratings are broadly balanced. Investment could revive faster than expected if confidence builds on the back on an advancing reform agenda. Stronger growth combined with ongoing fiscal discipline could materially improve the outlook for debt sustainability. On the other hand, political support for the reform agenda could lose momentum or external conditions could substantially worsen, thereby leaving Brazil vulnerable to shocks in a low growth – high debt equilibrium.

RATING DRIVERS

The ratings could experience upward pressure if the underlying fiscal position materially improves and the political support for sound fiscal management remains strong. Economic reforms that improve the growth outlook would also be credit positive.

On the other hand, the ratings could experience downward pressure if the fiscal adjustment deviates materially from the expected consolidation path. External shocks that exacerbate Brazil’s growth challenges could make the necessary fiscal adjustment even more difficult to achieve.

RATING RATIONALE

Pension Reform Reduces Fiscal Risks But Additional Measures Are Needed To Ensure Sustainability

The government is implementing a gradual fiscal consolidation plan 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 2018 and will likely be achieved in 2019. However, pursuing an expenditure-based consolidation is complicated by the high share of mandatory spending that is either earmarked or indexed.

Pension reform will help alleviate rising pressures on mandatory spending. If fully approved, the reform will stabilize pension spending as a share of GDP. While this reduces a key source of risk, prospects for narrowing the fiscal deficit will depend on the implementation of additional measures. Controlling the civil servant wage bill, restraining minimum wage adjustments that feed through to various expenditures, and removing tax subsidies will all likely be required in order to comply the spending cap through 2026, at which point the rules related to the ceiling can be amended.

Public debt dynamics are expected to stabilize but risks to sustainability are high. Assuming compliance with the spending cap, DBRS estimates that the primary balance would shift to a surplus in 2023 and then rise to 1.7% of GDP in 2026. In such a scenario, gross non-financial public sector debt (based on IMF definition) would peak in 2024 at 96% of GDP and then gradually decline. However, risks to the baseline scenario are two-sided. In a positive scenario characterized by compliance with the spending cap, stronger growth on the back of economic reforms, and extraordinary receipts driven by windfall oil revenues and privatizations, the debt ratio could remain stable at 92% of GDP from 2019 to 2022 and then decline to 87% of GDP by 2026. On the other hand, if spending is not tightly controlled and the recovery fails to gain momentum, public debt ratios could continue to rise over the outlook period, thereby jeopardizing the sustainability of public finances and, potentially, macroeconomic stability.

Structural Reforms Could Improve Growth Prospects

The cyclical recovery is slowly advancing but Brazil’s medium-term growth prospects are weak. The IMF estimates potential growth at just 2.2%, even after assuming some benefits from the current reform drive. The poor outlook partly reflects a slowdown in labor force growth as the population ages, 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.

However, strong implementation of the government’s reform agenda could raise potential growth. Following up on reforms passed during the Temer administration, including labor market reform and credit market reform, the new administration aims to boost productivity by lowering the cost of doing business in Brazil, rationalizing tax policy, pursuing privatizations, and opening the economy to international competition. The central bank is also implementing micro-reforms to reduce credit intermediation costs. While DBRS anticipates that some measures, such as tax reform, will be politically challenging and are likely to proceed slowly through congress, other measures do not require legislation and can be enacted more quickly. Overall, the direction of economic policy is positive for the growth outlook, although the impact will likely be felt in the medium term.

The Current Political Landscape Presents Opportunities and Challenges

The opportunity lies in the fact that both Congress and the Bolsonaro administration appear to be supportive of fiscal consolidation and market-oriented reforms. This sets up the possibility of deep and far-reaching changes to Brazil’s policy frameworks and economic structure. However, governability remains a key risk. President Bolsonaro has a limited base in congress, and there is a high degree of party fragmentation, all of which could complicate efforts to build congressional coalitions sufficiently large to pass legislation.

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.

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. 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 also strengthen the effectiveness of monetary policy over time.

The banking system has weathered the prolonged period of economic weakness relatively well. Banks remain profitable and well-capitalized. Asset quality is benefiting from the modest recovery. 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 BBB (low) – BB range. Additional considerations factoring into the Rating Committee decision included: (1) the balance of risks to the fiscal outlook, which the Committee viewed to be negatively skewed relative to the baseline, and (2) the high degree of uncertainty regarding the growth outlook. The main points discussed during the Rating Committee include 1) the fiscal outlook, 2) the economic recovery and reform agenda, and 3) the political environment.

KEY INDICATORS

Fiscal Balance (% GDP): -7.3 (2018); -7.6 (2019F); -7.4 (2020F)
Gross Debt (% GDP): 87.9 (2018); 92.2 (2019F); 94.1 (2020F)
Nominal GDP (USD billions): 1,868 (2018); 1,836 (2019F); 1,908 (2020F)
GDP per capita (USD thousands): 9.0 (2018); 8.8 (2019F); 9.0 (2020F)
Real GDP growth (%): 1.1 (2018); 0.8 (2019F); 2.4 (2020F)
Consumer Price Inflation (%, eop): 3.7 (2018); 4.1 (2019F); 4.0 (2020F)
Domestic credit (% GDP): 47.7 (2018); 47.2 (Jun-2019)
Current Account (% GDP): -0.8 (2018); -1.5 (2019F); -1.6 (2020F)
International Investment Position (% GDP): -32.6 (2018); -35.2 (Jun-2019)
Gross External Debt (% GDP): 35.5 (2018); 37.3 (Mar-2019)
Foreign Exchange Reserves (% short-term external debt + current account deficit): 311 (2018); 337 (Mar-2019)
Governance Indicator (percentile rank): 49.1 (2017)
Human Development Index: 0.76 (2017)

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 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 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 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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