The impact of the COVID-19 pandemic and subsequent economic downturn have significantly hit Brazilian local and regional governments' (LRGs) overall tax collection, while increasing expenditure pressures. These factors have come on top of the LRGs' already weak fiscal stance. After several weeks of negotiations, the Bolsonaro administration passed a fiscal package to help Brazilian LRGs on May 27, 2020. Although S&P Global Ratings believes this package could alleviate short-term fiscal pressures, it won't necessarily solve and ensure fiscal sustainability for LRGs in the longer term. Additional uncertainties about LRGs' revenue and expenditure balances, a prolonged relaxation of Brazil's Fiscal Responsibility Law, and complicated and longer-than-expected debt renegotiation processes could eventually weaken our view of the LRGs' institutional framework. However, we don't currently include that in our base case because we already factor in many of the limits, rigidities, and weaknesses embedded in the institutional framework in which Brazilian LRGs operate.
The legislation recently passed includes a combination of debt and fiscal relief measures:
- The possibility of restructuring LRGs' debt service payments with the financial sector in 2020, including multilateral lending institutions (MLIs). We believe that the government intends to do this measure primarily with public banks BNDES and Caixa, which represent R$13.9 billion of LRGs' debt.
- Suspending LRGs' debt repayments to the central government in 2020, representing R$35.2 billion.
- Potential securitization of the LRGs' debt for a total of R$20 billion.
- Central government transfers of R$60.2 billion to support LRGs' expenditure needs this year. This amount is in addition to another R$25.6 billion for health issues and R$16 billion to compensate for the drop in LRGs' transfers revenues, actions that were implemented through provisional measures earlier this year.
- LRGs would not be allowed to adjust salaries in 2020 and 2021 (excluding categories directly related to pandemic containment), lowering medium-term operating expenditure pressures, which could represent savings of approximately R$100 billion.
Brazil's fiscal package to support LRGs--including transfers; debt relief with the central government, public banks, and MLIs; compensation for lower tax collection; and temporary suspension of municipal pension payments--is an overall R$191 billion, according to official data. This represents about 2.5% of Brazil's estimated GDP this year.
On May 27, 2020, President Bolsonaro vetoed a paragraph in the legislative bill that would have prevented the execution of LRGs guarantees and counter-guarantees, as well as another section that would have allowed further salary increases. We assume that the veto will prevail at Congress.
Below, we discuss the different issues that are relevant when considering Brazilian LRGs' creditworthiness going forward, such as their debt service payments and their creditors, fiscal imbalances, and their relationship with the sovereign.
Frequently Asked Questions
What entities are the main lenders of Brazilian LRGs' debts that would participate in the debt relief package?
Brazil's central government is the largest LRG creditor, representing about 61% of total debt. Brazilian LRGs have also borrowed from domestic banks such as Caixa Econômica Federal, Banco do Brasil S.A, and Banco Nacional de Desenvolvimento Economico e Social (BNDES). Loans from these institutions represent about 12% of LRGs' total debt. LRGs' foreign currency debt, which represents less than 10% of total debt, mostly consists of loans from MLIs such as the Inter-American Development Bank, World Bank, and CAF, among others. We think that this debt composition will likely persist in the next few years, and LRGs may even increase debt with the central government if they keep delaying their amortization schedules as the recent legislation allows for 2020.
|Brazilian LRGs' Debt Composition By Creditor|
|(Mil. R$)||Amount||% of total debt||Amount guaranteed by sovereign||% guaranteed by sovereign|
|Loans||R$ 258,107||23.6||R$ 210,774||81.7|
|Public banks||R$ 133,170||12.2||R$ 94,297||70.8|
|Multilateral lending institutions||R$ 101,240||9.2||R$ 99,651||98.4|
|Commercial banks||R$ 15,345||1.4||R$ 12,046||78.5|
|International development agencies||R$ 4,620||0.4||R$ 4,355||94.3|
|Other loans||R$ 3,732||0.3||R$ 425||11.4|
|Central government||R$ 669,909||61.2|
|Other debt (mostly rogatory)||R$ 166,822||15.2|
|LRGS' total debt||R$ 1,094,838||100.0|
How would S&P Global Ratings treat a suspension of LRGs' debt payments to the federal government?
As per our methodology for rating LRGs outside the U.S., we view debt extended by a central government to LRGs as an integral part of intergovernmental relationships, and a form of support the central government provides to the sector. Therefore, we don't view non-payment of intergovernmental debt as a default. In the case of Brazilian LRGs, their portion of intergovernmental debt (76% of their total debt) wouldn't constitute a default according to our definition. That said, in the last few years, we've concluded that instances of non-payment of intergovernmental debt have indicated a weaker-than-expected financial situation, which resulted in downgrades of Brazilian LRGs.
How do you view LRGs' debt service to financial institutions, including MLIs, under the relief package?
We consider it a default when an LRG fails to pay an obligation it owes to a municipal funding agency, a higher tier of government's financial arm, or a development or export bank, and the debt does not benefit or isn't expected to benefit from any form of ongoing or extraordinary support from a higher tier of government. One example of the latter would be when the central government uses or is expected to use one of its closest financial arms--typically a government-related entity (GRE) with an almost certain likelihood of support--to channel explicitly instructed extraordinary support to LRGs that would result in individual or system-wide debt relief. We wouldn't consider debt included in the debt relief program to be in default because the central government would simply be using the GRE as a tool to provide such support
As per our analytical framework, we wouldn't consider to be in default Brazilian LRGs that restructure their debts with BNDES and Caixa (two GREs with almost certain likelihood of support from the central government) as per the enacted bill. This is because we would assess that the central government would be channeling extraordinary support to the LRG sector through both of its closest financial arms.
As for debt provided by other financial institutions, including MLIs, in the absence of other forms of support provided by the central government, we would assess each LRGs' intention to defer or restructure this debt on a case-by-case basis under our distressed exchange criteria. If an LRG misses a payment and the central government steps in within the timeframe established by the guarantee terms, we wouldn't consider the LRG to be in default.
What's your assessment of the institutional framework for Brazilian LRGs?
In our view, Brazilian LRGs have been operating in a volatile and unbalanced institutional framework that has limited their credit quality over the years. One of the framework's main weaknesses is structural fiscal rigidities that haven't allowed for the correction of significant budgetary imbalances, as well as the high debt levels relative to international peers that have persisted even with limited access to external financing. Historically, an overly generous compensation and pension system, constitutional expenditure mandates, and high debt service levels reduced the discretionary share of LRGs' expenditures. In addition, an overcomplicated tax system and tax wars between states jeopardized LRGs' capacity to raise additional revenues. This situation also becomes more complicated during economic downturns.
Since the approval of the pension reform at the federal level, several states have moved quickly to reform their pension systems, which we consider a very strong step in the right direction to address fiscal rigidities. That said, the COVID-19 pandemic has shifted political priorities and weakened the momentum to address fiscal woes with other reforms, such as the broad tax reform currently in Congress and revision of the federal pact that would alleviate the states and municipalities' funding needs as well as establish clearer roles and responsibilities for local governments, with a longer term vision.
In short, we believe that our current institutional assessment already incorporates all of the system's shortcomings, but a weakening in the relationship between states and the sovereign, or increasing fiscal deficits at subnational level beyond our assumptions, could eventually affect our assessment of Brazilian LRGs' institutional framework.
Why do you believe that the fiscal package is more of a short- term fix for LRGs' fiscal constraints?
As mentioned above, Brazilian LRGs face structural fiscal rigidities in regards to their expenditures composition (over 50% of their total expenditure mix is composed of personnel and interest payments), while capital expenditures (capex) have been consistently restricted over many years (and only represented 6% of total expenditures in fiscal 2019). Revenues have also suffered during the prolonged recession in the past few years, and are currently depressed due to the measures to limit COVID-19. As a result, LRGs continue to struggle to balance public finances and have limited access to external financing.
The fiscal measures the government has passed are intended to help LRGs gain some liquidity this year by renegotiating debt with public banks, suspending their debt payments to the federal government, and by giving them a fixed amount of transfers. However, these are short-term measures. We still need to assess what type of incentives these policies create, and if Brazilian LRGs will see these relief measures only in 2020-2021 or if they'll request new packages in the future. We anticipate that Brazil's economic recovery may be slower than previously expected because of continued effects from the pandemic, which could hurt LRGs' revenues and keeping pressuring operating spending. Overall, we think LRGs' long-term structural issues aren't up for discussion at this point, and therefore will continue for at least the next few years.
Do you assume that the sovereign will keep the existing guarantees mechanism for LRGs' debt unchanged?
The federal guarantees system is one of the pillars of the fiscal framework in Brazil. Guarantees allow subnational governments to borrow at rates comparable to those of the federal debt. The National Treasury has stepped in to honor the guarantees, according to its own policies and timeframe. Following the execution of the guarantee, the Treasury then executes the counter guarantees--a well-established mechanism of automatic retention of federal transfers and local tax revenue--for the same amount as the debt honored. Since 2016, given the increasing budgetary pressures on local governments as the recession has deepened, a growing number of LRGs have turned to the sovereign to honor their guaranteed debts. As of December 2019, states and municipalities' outstanding guaranteed debt amounted to about $55 billion (3% of GDP). In 2019, the federal government paid $2.1 billion in debt that was originally borrowed by states and municipalities. Since 2016, the total debt honored by the federal government has reached over $5.5 billion.
In November 2019, the government sent to Congress the proposal for a federative pact (a proposal to amend the constitution; called PEC 188/2019), which aims to reduce LRGs' financial dependence on the sovereign. The reform proposes to ban federal guarantees as of 2026, except for loans from MLIs. However, in the context of the COVID-19 pandemic and a more challenging political and economic scenario for Brazil, we now believe the government might face more challenges in advancing its economic and fiscal agenda, in particular the reforms that require constitutional amendments. Therefore, without a significant change to the existing borrowing framework, we expect the mechanism of sovereign guarantees to continue over the next three years.
Do you believe the fiscal package will affect MLIs' preferred creditor status?
The legislation suggests that LRGs can negotiate the deferral of interest or principal to MLIs. However, loans from MLIs to Brazilian LRGs are accompanied by a sovereign guarantee by the Brazilian central government. In the past, if a LRG missed a principal or interest payment, the sovereign would step in and honor its guarantee within the 180 day window, although more commonly within 30 days of the missed payment.
The cornerstone of the MLI business model is the preferred creditor status afforded by sovereign members. In practice, this has translated in privileges and immunities for MLIs, such as exemptions from participating in sovereign debt rescheduling, lower sovereign default rates, and better loan recoveries compared to commercial creditors. If a sovereign fails to pay its obligation to a MLI within a 180 day window, the MLI will place all exposures on non-accrual, and will freeze loan approvals and disbursements until the arrears are cleared. We assess the strength of a MLI's preferred creditor treatment status by considering whether interest or principal is overdue beyond 180 days, which can weigh on the MLI's enterprise risk and financial risk profiles.
We expect that the Brazilian government will continue to honor its sovereign guarantees to MLIs in a timely manner, irrespective of the legislation. First, we have never recorded arrears in any of the MLIs that have exposure to the Brazilian sovereign. Second, MLIs provide important countercyclical financing that the sovereign would lose access to if they were to default. Lastly, it's the Brazilian central government that determines which LRGs are eligible to receive multilateral financing based on the central government's internal debt sustainability analysis. In the event that the sovereign did not honor its guarantee because of missed debt payments from LRGs, we would consider the loan to be in arrears with likely negative impacts on the MLI ratings--however, the sovereign has always honored these guarantees in the past.
Relief Measures Could Be An Opportunity For LRGs
Overall, we believe the LRGs' fiscal package provides near-term relief for LRGs, but it doesn't address key structural public finance issues. For example, while LRGs' salary freezes in 2020-2021 could help contain wider fiscal imbalances, the freezes don't solve the overall budgetary rigidities imposed by high payroll expenditures for both active and non-active civil servants. This stressed period could be an opportunity for Brazilian LRGs to reassess the structural issues that are dragging down their finances. However, thus far we haven't seen evidence of the LRGs developing a longer-term vision to strengthen their fiscal sustainability post pandemic.
This report does not constitute a rating action.
|Primary Credit Analyst:||Daniela Brandazza, Mexico City (52) 55-5081-4441;|
|Secondary Contacts:||Manuel Orozco, Sao Paulo (55) 11-3039-4819;|
|Victor C Santana, Sao Paulo + 55 11 97625-7027;|
|Livia Honsel, Mexico City + 52 55 5081 2876;|
|Alexis Smith-juvelis, New York + 1 (212) 438 0639;|
|Lisa M Schineller, PhD, New York (1) 212-438-7352;|
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