Moody’s Investors Service raised the Brazilian credit rating outlook from negative to stable. Now Brasil is positioned with a’Ba2′ or two levels below investment grade. According to the rating agency, Brazil’s economy has shown signs of improvement, with inflation on a downward trajectory and improvement under the fiscal perspective.
Moody’s decision to change Brazil’s outlook to stable was driven by the following factors:
Moody’s expectation that the downside risks reflected in the negative outlook are abating and macroeconomic conditions stabilizing, with the economy showing signs of recovery, inflation falling and the fiscal outlook clearer.
Indications that the functioning of Brazil’s policy framework is improving and the strength of its institutions recovering, supporting planned implementation of structural fiscal reforms
Risk of contingent liabilities from government-related entities, captured in the negative outlook, has been significantly reduced over the past six months, downside risks to the Ba2 rating have abated and macroeconomic conditions have stabilized in Brazil, with an incipient recovery in economic growth expected in 2017 and faster-than-anticipated fall in inflation. A positive reform momentum emerged last year, indicating improved functioning of institutions that would support implementation of fiscal reforms and passage of the social security reform this year. Contingent liability risks related to financial support to Petrobras have diminished, reducing downside risks, while the fiscal cost of debt relief provided to state governments remains contained. Overall, the government debt trajectory remains in line with our earlier expectations for 2017-19 and consistent with the Ba2 rating.
RATIONALE FOR CHANGE IN BRAZIL’S RATING OUTLOOK TO STABLE
First Driver: Moody’s expectation that the downside risks reflected in the negative outlook are abating and macroeconomic conditions stabilizing. A more benign outlook for growth and inflations underpin our expectation of broad macroeconomic stabilization. Although growth may still disappoint to the downside, we expect an end to the very severe economic contraction that persisted for the past two years, reducing downside risks. We expect GDP growth between 0.5-1.0% this year and 1.5% in 2018, and inflation to drop to 4.5% in 2017, which is the central bank target. After 2018, we expect growth to stabilize around 2-3%. The drop in inflation has allowed the central bank to begin an easing cycle, cutting the policy rate from 14.25% to 12.25%, with further easing expected in 2017 in line with still weak economic activity. Although the fall in interest rates will likely have only a limited impact on economic activity in 2017 due to ongoing deleveraging cycle and weak household demand, we expect a positive impact on the government’s interest bill, arresting the deterioration in Brazil’s fiscal profile.Despite an improved macroeconomic outlook, fiscal results will remain weak in the near term. In 2016, the primary deficit reached 2.7% of GDP and we expect a similar result this year. We expect Brazil’s debt-to-GDP ratio will rise from 70% of GDP at end 2016, to around 80% by 2019 as tepid and gradual economic recovery weighs on government revenues, contributing to high deficits. However, Brazil’s debt structure has several features that mitigate the risks of a relatively large stock of public debt, including limited exposure to exchange rate depreciation and a diverse and large domestic investor base. In addition, a significant portion of government debt is issued to the central bank as monetary policy instrument, and does not represent a financing need for the government. In this context, Brazil’s debt trajectory remains consistent with the Ba2 rating.
Second Driver: Indications that the functioning of Brazil’s policy framework is improving, supporting planned implementation of structural fiscal reforms. The political uncertainty that weighed on Brazil’s outlook has subsided relative to a year ago, supporting improved effectiveness in passing fiscal reforms, and suggesting that Brazil’s institutions are beginning to function more effectively. A sustained improvement in the functioning of the country’s legislative and executive institutions will support achievement of a range of credit positive economic and fiscal reforms that have been identified as needed to support recovery. The government has already passed an important constitutional amendment to cap primary government spending growth at the rate of last year’s inflation for the next twenty years, and Congress is discussing an equally important reform of social security, which we expect will pass in the second half of 2017. The government also plans to present structural reforms to boost potential growth, including simplifying the tax code and introducing labor reforms. Consistent compliance with the cap on primary (non-interest) spending, and curtailing the growth of social security spending, are both necessary to protect fiscal sustainability by curbing the increase in government spending, which has grown in real terms from 14% of GDP in 1995 to just under 20% of GDP last year.
Third Driver: Risk of contingent liabilities from government related entities, captured in the negative outlook, has been significantly reduced. The contingent liability risk related to Petrobras, which was another driver behind the negative outlook on Brazil’s rating, has been materially reduced with the steps taken to address the company’s problems and to support its liquidity and market access through progress on asset sales and improved management practices. Set against that, another source of contingent liability has emerged in the state government sector, the fiscal position of which continued to deteriorate. A number of state governments have called for support from the federal government in the form of debt rescheduling. However, the fiscal impact of this support remains contained at R$20 billion (0.3% of GDP) in 2016 with similar magnitude expected in 2017-18.