RaboResearch - Economic Research

Brazil is back to junk

Economic Comment

  • Brazil lost its investment grade with S&P on 9 September
  • There has been some impact on financial markets, but a second downgrade to junk could be more damaging. While Brazil is vulnerable to a reversal of capital flows, a high level of FX reserves limits acute balance of payments risks
  • The downgrade nonetheless underlines Brazil’s enormous fiscal challenges. Political headwinds could further darken the fiscal and economic outlook

S&P downgraded Brazil’s foreign currency sovereign rating by one notch to BB+ on 9 September, stripping Brazil of its investment grade obtained in April 2008. A negative outlook was maintained, indicating there is a greater than one-in-three chance of a further downgrade. The domestic currency sovereign rating was also downgraded, but remains one notch above junk status. Backtracking on fiscal consolidation on the back of increasing political headwinds was the main trigger for the downgrade. Brazilian authorities have revised the primary balance target for 2016 twice within a 6-week period from a 2% of GDP surplus to a 0.3% of GDP deficit. Also, congress has continued to frustrate the introduction of various revenue increasing measures in recent weeks. 

Limited direct impact…

The downgrade has had some impact on financial markets, but a subsequent downgrade to junk by another agency might be more damaging. The rating action was not a surprise and sentiment had already been deteriorating before the downgrade (figure 1). Bond yields went up by 40 basis points and the real depreciated by 2% against the USD on 10 September. Moody’s and Fitch still maintain an investment grade rating and recent statements suggest that this is unlikely to change in the very short term. However, losing investment grade with a second agency could have more impact, as some Emerging Market Indices and institutional investors could then no longer invest in Brazil.

Brazil is vulnerable to a reversal of capital flows, but short-term balance of payments risk remains rather low. Brazil’s large current account deficit (above 4% of GDP in the first 7 months of 2015) is no longer fully covered by gross FDI inflows, which renders the country vulnerable to market sentiment and a reversal of capital flows. This vulnerability has only increased in the first 7 months of 2015, as the FDI current account deficit coverage ratio fell to 55%, from 63% a year earlier. On top of that, low commodity prices and worries about China and an imminent rate hike in the US have put portfolio flows to emerging markets (EM) under stress in recent months (figure 2). However, a high level of foreign exchange (FX) reserves (15 month import cover in August 2015) provides mitigation against balance of payments stress.

Figure 1:Market sentiment has been deteriorating for a while now
Figure 1:Market sentiment has been deteriorating for a while nowSource: GFI Group, Macrobond, BM & FBOVESPA, Rabobank
Figure 2: Portfolio flows to EM’s under stress
Figure 2: Portfolio flows to EM’s under stressSource: IIF, Rabobank

… but the downgrade underlines that fiscal consolidation is an enormous challenge

Nonetheless, the downgrade increases financing costs for both corporates (S&P also downgraded the ratings for many corporates) and the government, and that is particularly bad news for public finances. Brazil has a relatively high (certainly by Emerging Market standards) public debt burden and high interest rates. Interest payments increased by 70% to a sizeable 7.1% of GDP between 2012 and 2015 (figure 3). The government seems trapped in a vicious circle, as higher refinancing costs further hurt public finances, which in turn could lead to further rating downgrades. Meanwhile, as the Brazilian economy slid into recession in 2015 and is witnessing the largest contraction in the past two decades, public revenues have also taken a hit. As congress also keeps frustrating consolidation efforts, the government is having difficulties restoring a primary surplus.

Figure 3: Budget deficit grows as primary balance deteriorates and interest costs go up…
Figure 3: Budget deficit grows as primary balance deteriorates and interest costs go up…Source: EIU, Rabobank
Figure 4. … resulting in an increase of public debt
Figure 4. … resulting in an increase of public debtSource: EIU

Political headwinds bode ill

Achieving fiscal consolidation will be very difficult. Political tensions, exacerbated by the Lava Jato corruption scandal, were one of the main causes for the backtracking on fiscal consolidation, as also highlighted by S&P in its report. The fact that Brazil has moved closer to a second, more damaging downgrade, might give Brazilian politicians a sense of urgency and facilitate fiscal consolidation efforts. However, politicians might also regard the junk status as a fait accompli and reduce the already low and fickle support for fiscal consolidation measures, especially as political investigations in Lava Jato are expected to pick up in coming months and increase tensions. This could lead to a departure of Minister of Finance Levy and/ or a presidential impeachment. Both would seriously hurt governability and policy and further darken Brazil’s economic outlook.

Alexandra Dumitru
RaboResearch Global Economics & Markets Rabobank KEO
+31 6 2326 6856

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