DBRS has upgraded the Long-Term Foreign and Local Currency-denominated debt of the Federative Republic of Brazil to BBB (low) from BB (high) and changed the trends to Stable from Positive.
The reasons for the upgrade are a series of developments, both structural and policy-driven, that together strengthen credit quality. These are: (1) greater predictability of macroeconomic policies through a growing consensus across political parties in favor of an orthodox fiscal, monetary and exchange rate policy framework; (2) a structural strengthening of general government revenues from more efficient tax collection, greater availability of bank credit and formalization of the labor force; (3) improvement in the size and structure of public debt; and (4) a more-resilient external balance sheet due to Brazil’s net external creditor position, high and rising external liquidity, ongoing export diversification and robust foreign direct investment inflows which, together with oil and gas discoveries, brighten the investment outlook. “The Stable trend signals our expectations that the government will continue to implement a generally prudent macroeconomic policy framework following mid-term elections this October and presidential elections in 2010,” said Fergus McCormick, DBRS’s Brazil analyst.
The trend also incorporates the view that a more stable economy provides scope for further improvements in debt dynamics and a medium-term decline in average real interest rates. Combined with an operationally independent Central Bank that has adopted a pre-emptive monetary stance, Brazil’s position as a net exporter of food and fuels reduces inflation risk in the coming months. An important consideration in the decision to upgrade the ratings is DBRS’s belief that the sound macroeconomic policy framework outweighs a recent deterioration in the quality of public spending.
As Brazil has demonstrated since 1999, the public sector is committed to meeting its primary surplus targets while respecting the Central Bank’s mandate to tighten monetary policy in the presence of higher inflation pressures. In spite of high primary spending on wages, pensions and infrastructure investment, strong tax revenues provide the government with ample room to meet its primary targets. DBRS draws comfort from the fact that greater formal employment, combined with an expansion in credit has swollen the ranks of taxpayers. The cumulative effect of years of rising real wages and transfers from the Bolsa Família program appears to have improved social welfare, and to be partly responsible for higher tax receipts.
Earlier this year, DBRS called for more durable fiscal management and an adequate replacement to the loss of the CPMF financial transactions tax. In fact, the government announced it would plug the gap in the budget by cutting expenditures, raising the IOF financial operations tax, and accruing higher tax revenues as economic activity expanded. Since January, expenditure cuts have been slow to materialize. However, higher-than-expected tax receipts are sufficient to replace the lost revenue. Still, from a medium-term perspective, a range of structural distortions burdens public finances and the stability of the ratings will be a function of further progress in reducing these distortions. High tax rates and an uneven and complicated tax system curtail productivity growth and crowd out investment.
Approval of a pending nationwide value-added tax reform would help to correct many of these distortions and contain inflation expectations. Second, the public sector pension deficit will need to be reduced with additional reforms. Third, while in decline, public debt is high and interest payments on federal securities offset primary surpluses. One-quarter of federal debt matures within one year, leaving the government exposed to rollover risk and higher debt costs should lender confidence deteriorate.
Overall, DBRS expects that this and future governments will preserve a sound policy framework. However, policy reversals or an abandonment of the reform agenda could derail the trend of credit improvement.
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