The Daily Update - Brazil

Brazil looks to be in the midst of a perfect storm. On our 2011 net foreign asset estimates, Brazil at 47 percent net foreign liabilities (NFL) as a percentage of GDP was within our cut off of less than 50 percent NFL; IMF research indicates levels above this threshold are associated with increasing risk of external crises. But we have avoided Brazil due to its deteriorating economic fundamentals. In the past seven trading days the yield on the USD 4.25% January 2025 Brazilian sovereign debt has backed up 44 basis points to 5.57% suggesting the market is rapidly losing confidence and last week Brazil cancelled a local government debt auction citing poor market conditions.

Reasons for the loss of confidence include; First, the President Dilma Rousseff’s popularity has reached an all-time low; corruption investigations into the misuse of funds from Petrobras, the state-controlled oil company, have continued to spread and escalate through the senate and lower house leading to public demonstrations calling for her impeachment. Second, the Brazilian economy has been in recession falling 1.9% in Q2 after shrinking 0.7% in Q1. Plus, the Brazilian real has plummeted and inflation has remained stubbornly high. Third, Brazil’s current budget deficit including interest payments is ~8.8 percent of GDP and on August 31 the 2016 draft budget projected primary deficit of 0.5% of GDP, the first deficit since the Fiscal Responsibility Law was enacted in 2001, and well down from the 2% surplus target at the start of the year. Admittedly, scope for manoeuvre is limited with 90% of spending predetermined, but there is now the concern whether the Finance Minister, Joaquim Levy will remain in office. Earlier in the year Joaquim Levy’s appointment had instilled confidence, particularly for the rating agencies, that a more prudent and appropriate economic policy with fiscal reform would be undertaken but he has struggled to get reforms implemented; the budget forecasts have been downgraded twice in the past couple of months. The targets for 2017 and out to 2019 also look optimistic to say the least. Dilma Rousseff lacks support to pass measures to address the fiscal problem and Joaquim Levy is now looking increasingly isolated.

Brazil’s sovereign rating is still investment grade but this is looking increasingly under pressure. On July 28, S&P downgraded the outlook on Brazil to negative but maintained its BBB- long term foreign currency rating reflecting “challenging economic and political circumstances” citing negatives such as the corruption scandal and increased risks to effective policy implementation. S&P stated that they could lower the ratings if “there were further deterioration in Brazil's external and fiscal indicators resulting from what we might view as a backtracking by Brazil from its commitment to its stated policies.” They go on to state “Over the coming year, failure to advance with (on- and off-budget) fiscal and other policy adjustments could result in a greater-than-expected erosion of Brazil's financial profile and further erosion of confidence and growth prospects, which could lead to a downgrade.” This now seems precisely the path that Brazil is taking and general government gross debt to GDP looks likely to exceed 70% in 2016.

Moody’s also downgraded its rating of Brazil on August 11 to Baa3 with a stable outlook citing weaker than expected economic performance, a lack of fiscal reform and deterioration in debt affordability as the debt to GDP ratio continues to rise. Moody’s state “The rating could come under additional pressure if government debt metrics were to deteriorate further and faster than we expect, and if we were to conclude that Brazil was unlikely to achieve the growth and fiscal consolidation needed to ensure fiscal sustainability over the medium term. In our view, Brazil needs to achieve GDP growth and primary surpluses of at least 2% of GDP during the second part of this administration to arrest the rise in debt and provide assurance of fiscal sustainability beyond the span of this administration.“

While a combination of high level of international reserves, and foreign direct investment flows which offset to a large extent the current account deficit of ~4% of GDP, reduce Brazil’s external vulnerability, the absence of more effective policy and macroeconomic management over the next 12-18 months will put its sovereign rating at risk of being downgraded to junk.