Brazil has been one of the sovereigns worst affected by the COVID-19 pandemic globally, although the pace of new cases has slowed recently. Social distancing measures--the severity of which has varied from state to state--have hit the economy hard, but substantial fiscal and monetary support implemented by the authorities will likely mitigate their impact.
The pandemic exacerbated some of Brazil's key structural weaknesses, primarily low economic growth and a high government debt burden, limiting the government's ability to withstand the short-term shock while preserving fundamentals. S&P Global Ratings expects the economic recession and government support measures to lead to a record fiscal deficit and a significant surge in government debt in 2020. Moving into the fourth quarter of 2020, attention has returned to fiscal adjustment and progress on the government's reform agenda, both of which are necessary conditions to ensure debt sustainability over the medium term.
We affirmed our 'BB-' long-term and 'B' short-term sovereign credit ratings on Brazil on April 6, 2020, and revised the outlook to stable from positive. While the pandemic has increased uncertainty regarding the reform agenda, we continue to see a broad commitment from policymakers to fiscal consolidation and economic reforms, even though political pressure has increased to extend the fiscal stimulus into next year.
In the political arena, disagreement between the executive and legislative powers has receded somewhat as President Jair Bolsonaro builds alliances with centrist parties. However, we expect political dynamics to remain fluid, considering the significant challenge of unwinding fiscal stimulus measures implemented this year and adhering to caps on public spending. The passage and implementation of significant structural reforms by the Bolsonaro Administration will depend on broader political support and on skillful leadership by politicians and economic policy officials.
Here we provide answers to questions raised by investors and other market participants about the current prospects for our sovereign credit ratings on Brazil.
Frequently Asked Questions
Why did S&P Global Ratings revise the outlook on Brazil to stable from positive earlier this year?
We revised the outlook in April to reflect diminishing prospects for an upgrade over the coming year due to the impact of the COVID-19 pandemic, as economic and fiscal conditions became much more challenging and therefore less conducive to material progress on the reform agenda. Our base case assumes gradual economic recovery and fiscal consolidation once the shock dissipates. It also reflects slower progress than we expected at the beginning of this year on reforms to address fiscal vulnerabilities and to improve poor medium-term GDP growth prospects.
Our ratings on Brazil are constrained by structurally large fiscal imbalances and low economic growth. On the other hand, large international reserves, low external debt, proactive monetary policy, a floating exchange rate, a favorable composition of sovereign debt, and a large and active local currency fixed-income market, which increase resilience to challenging and volatile global economic conditions, support the ratings.
Brazil has responded to the COVID-19 shock with a large support package; how could this affect its fiscal performance?
The policy response will worsen already weak fiscal performance, at least in the short term. Brazil registered primary fiscal deficits for six consecutive years prior to the pandemic, contributing to general government deficits averaging almost 8% of GDP. In 2019, the general government deficit declined more than expected--to 6% of GDP--as a result of fiscal consolidation measures, nonrecurring revenue, and lower interest rates, while the net general government debt dropped by 2 points of GDP to 55.3%.
Brazil's fiscal vulnerability has made it hard for the government to design measures to minimize the effects of the pandemic. A declaration of public emergency allowed the government to suspend the primary fiscal target and its fiscal "golden rule." The authorities announced fiscal measures amounting to almost 12% of GDP, of which the direct impact in the 2020 primary deficit is estimated at 8.4% of GDP (Brazilian real [R$] 605 billion announced to date, of which R$584 billion is new spending and the rest is lower revenue). The most significant step is an emergency aid program, which has benefited more than 50 million people and amounts to R$322 billion (or 4.5% of GDP).
While Latin America in general has less space for countercyclical fiscal policy compared with the average of the G-20 sovereigns, as reflected by materially lower sovereign credit ratings, Brazil's fiscal response to the pandemic and economic shock has been large for regional standards (see chart 1).
As a result of these developments, we expect the general government deficit to reach a record-high 15% of GDP in 2020, and net general government debt to exceed 70% of GDP (from about 60% of GDP in July). We could revise our projections depending on economic performance and adjustments to fiscal measures. Our current base-case scenario assumes that fiscal consolidation will resume once the shock dissipates, allowing for the fiscal deficit to gradually decline in the next three years.
However, economic weakness exacerbates execution risk in our view. If Brazil's fiscal results are persistently weaker than we expect, resulting in continued large deficits and quickening the rise in debt burden, they could lead to lower creditworthiness. A material and sustained policy commitment to fiscal prudence will remain essential.
There is increasing debate in Brazil about compliance with a constitutional spending cap. How does S&P Global Ratings analyze the question from a ratings perspective?
Several countries in the region, including Chile, Peru, Colombia, and Brazil, have adopted fiscal rules in recent decades to encourage political commitment that will strengthen the sustainability of public finances in the medium and long term. The level of compliance with the rules underpins the credibility of fiscal policy and can help reduce investor perceptions of risk. During economic downturns or periods of rising political and social pressures, the risk of altering the fiscal rules increases.
In Latin America, the level of compliance with the rules has varied widely. When analyzing a sovereign credit rating--and while the rules could play an important role in aligning political incentives with fiscal responsibilities--we focus more on fiscal outcomes than on strict compliance with the fiscal rules.
Brazil passed a constitutional amendment in December 2016 to put a 20-year cap on public spending growth, which cannot exceed the previous year's inflation rate (although about 20% of total spending is not subject to the rule). The spending cap helped anchor expectations about fiscal adjustment. It has also helped to reduce inflation expectations and therefore to improve monetary policy flexibility. Mandatory spending, such as public-sector pensions, salaries, and social security, accounts for more than 90% of total spending, leaving little room for discretionary expenditure, such as capital and administrative expenditure.
Brazil passed a social security reform in October 2019 that should help stabilize such spending as a share of GDP (currently about 10% of GDP) in the coming years. Nevertheless, compliance with the fiscal rule will depend on more reforms to control other components of mandatory spending. The activation of automatic spending adjustments--such as cutting working hours and salaries and freezing career progression--when the debt ceiling is about to be breached (as envisaged in the constitutional amendment on fiscal contingency presented in Congress in November 2019) would reduce spending pressure, but only in the near term.
Debate is growing about modifying the fiscal rules, given demands for more spending next year on extended social programs or infrastructure projects (in 2020, the approval of the "war budget" allowed for temporary emergency spending above the spending cap). However, there is a risk that altering the spending cap, in a context of high volatility, could erode political consensus on the importance of fiscal responsibility and cause uncertainty among market participants, leading to potential negative effects on economic recovery, financial stability, and inflation expectations. The impact on sovereign creditworthiness ultimately will depend on many factors, including the nature, size, and length of any fiscal changes, the implementation of compensatory measures, and progress on the reform agenda.
How does S&P Global Ratings assess the outlook for the passage of structural reforms?
The current administration has shown commitment to policies that strengthen Brazil's fiscal accounts and encourage greater private-sector participation in the economy. However, the lack of a solid coalition in Congress has posed a challenge in advancing the economic and fiscal agenda, in particular because several reforms require constitutional amendments (PECs by their Portuguese acronym), a critical aspect of Brazil's institutional framework. PECs need to be approved in two rounds of three-fifths majority votes in both chambers of Congress (equivalent to 308 deputies and 49 senators)--a long and cumbersome process.
Recently, President Bolsonaro allied with centrist parties, which together hold about one-third of the seats in the lower house. This, along with a recent increase in his popularity, could accelerate negotiations on the reforms. Nevertheless, we expect political dynamics to remain fluid, especially given the schedule of elections in the next two years (municipal elections in November 2020 and presidential elections in October 2022). On the other hand, leadership from Congress, which will elect a new speaker of the lower house in February 2021, will also be key in approving the reforms.
Legislative activities will probably slow down ahead of the November municipal elections as several lawmakers run for office or participate in campaigns. Therefore, the debates around structural reforms could lose momentum. The government has submitted its administrative reform proposal, a civil service reform that would apply only to new hires. In addition, Congress is now discussing three reforms aimed at streamlining and simplifying the tax system.
We believe it will take time to advance these constitutional amendments because many parties are involved in the debates. Even if they are approved in 2021, we do not expect the measures to have a near-term impact. On the other hand, microeconomic and regulatory reforms--which do not require constitutional amendments--are more likely to advance, as shown by the passage of a new sanitation bill that enlarges private-sector participation in the industry.
Why are Brazil's external profile and government debt composition considered relative strengths of the rating?
We expect Brazil's external profile to remain resilient, despite heightened global volatility. Compared with other emerging markets, Brazil has smaller current account deficits, limited public-sector external debt, higher foreign exchange reserves, and a favorable composition of debt that limits external vulnerability.
We assume a reduction in the current account deficit in 2020 (toward 1.4% of GDP) as a result of higher commodity exports and a decline in imports. Foreign portfolio investment registered significant outflows in the first half of the year but recently recovered. Foreign direct investment (FDI) in the country also declined (to US$25.5 billion in January-July 2020 from US$36.5 billion last year), but we expect FDI to counterbalance the exit of portfolio investments and remain the largest source of financing for the current account deficit.
Regarding private-sector debt, local companies rolled over a significant amount of external debt (held by nonresidents and largely denominated in U.S. dollars) last year and increasingly took on internal debt (reducing their foreign exchange exposure). Brazil ended the 2016-2019 period with a narrow net external creditor position according to our definition, which deducts central bank reserves and external assets from the banking system from the country's gross external debt. Nevertheless, Brazil has a significant net external liability position (due to the large stock of FDI in the country), suggesting its external accounts are vulnerable to the risk of marked deterioration in the cost of or access to external financing.
A favorable composition of debt mitigates the risks of managing Brazil's high debt burden. Government debt remains overwhelmingly in local currency (see chart 4). The share of nonresident holdings of domestic public debt is at a 10-year low at about 9% (compared with 19% in December 2015). The local market for refinancing has proved a reliable source of funding.
What are S&P Global Ratings' expectations for economic recovery after COVID-19?
Recent economic data suggest activity is recovering from sharp declines in April-May, although the recovery is uneven and reliant on fiscal stimulus. The labor market is expected to remain weak until next year, but the extension of the emergency aid program through December (albeit with payments reduced by half to R$300 per month) can help sustain economic activity in the fourth quarter. However, uncertainty is growing about the recovery in 2021, after the fiscal support measures end. Another risk could come from an acceleration in COVID-19 cases, leading to more restrictive quarantine measures. For 2021, our GDP forecast is 3.5%.
Before the pandemic, Brazil's potential growth was about 2%, one of the lowest rates among emerging markets. Raising the country's long-term GDP growth rate depends on reforms to increase productivity and private investment. Simultaneously, sustained fiscal consolidation requires stronger and persistent economic growth to generate more tax revenue. A slower pace of economic recovery next year could result in less favorable political conditions for passing difficult economic reforms, which highlights the importance of political leadership across governing institutions to address deep-seated weaknesses that constrain the sovereign rating.
- Sovereign Rating Methodology, Dec. 18, 2017
- Brazil Outlook Revised To Stable From Positive On Uncertainty Related To COVID-19; 'BB-/B' Ratings Affirmed, April 6, 2020
- Americas Sovereign Rating Trends Midyear 2020, July 30, 2020
- Global Sovereign Rating Trends Midyear 2020: Outlook Bias Turns Negative As Governments Pile On Debt To Face COVID-19, July 30, 2020
- Sovereign Risk Indicators, July 14, 2020
- Emerging Markets: The Long Road To A New Normal, July 13, 2020
- Credit Conditions Emerging Markets: Slow Recovery, Prevalent Risks, June 30, 2020
- Economic Research: Latin American Economies Are Last In And Last Out Of The Pandemic, June 30, 2020
This report does not constitute a rating action.
|Primary Credit Analyst:||Livia Honsel, Mexico City + 52 55 5081 2876;|
|Secondary Contacts:||Sebastian Briozzo, Buenos Aires (54) 114-891-2185;|
|Joydeep Mukherji, New York (1) 212-438-7351;|
|Lisa M Schineller, PhD, New York (1) 212-438-7352;|
|Nicolemarie Schmidt, Mexico City;|
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