Risk drivers and outlook

With the unwinding of the commodity boom, the Brazilian economy started to slow down in 2011. More recently, a confidence crisis – chiefly sparked by policy uncertainty regarding adherence to the ‘holy trinity’ macroeconomic framework, tightening financial conditions and a cooling labour market – exposed the exhaustion of the consumption-led domestic growth model. The economy stagnated, public finances deteriorated, inflation surged, the exchange rate plummeted, the current account deficit deepened and external debt ballooned. This worsening of fundamentals led Credendo Group to downgrade its classification for MLT political risk in Brazil to category 4 (from 3) in May 2015.

Since that time, the negative trend has continued and risk fundamentals have further deteriorated. This is due not least to a severe political crisis that has inhibited the type of effective policy making that is required to address structural flaws and boost confidence. In particular, investigations into a multi-billion US dollar kick-back scheme unearthed at state-owned oil company Petrobras have seen many high-level politicians as well as top entrepreneurs jailed, and accusations of fiddling with fiscal accounts have seen the mandate of President Rousseff suspended. In this context, it is expected that Rousseff will be definitively impeached later this year and that acting President Temer will remain in control until the 2018 presidential election. Given the highly volatile political situation, however, it remains to be seen whether his administration will manage to reboot the economy.

This context has seen the classification for MLT political risk further downgraded to category 5 (from 4) in July 2016. Commercial risk in Brazil has evidently deteriorated as well. The on-going recession, contracting credit provision to the private sector and the recent currency depreciation imply that the country classification for commercial risk is in the highest category. Yet while commercial and solvency risk have clearly risen, the still-huge buffer of international reserves implies that liquidity risk has not. As such, the Credendo Group classification for ST political risk has remained stable in category 2.

Facts & figures

Pros

  • Huge natural resource potential
  • Much-reduced poverty
  • Vast international reserves

Cons

  • Economy in recession
  • Political crisis
  • Rising external debt

Main export products

  • Manufactured goods (27.9% of current account receipts), soy (8.3%), oil (7.4%), sugar (2.7%), tourism (2.4%), coffee (2.2%), beef (2.1%)

Income group

  • Upper middle

Income per capita

  • USD 11,760

Population

  • 202 m

Description of electoral system

  • President and Chamber of Deputies: 4-year term, last election: October 2014
  • Federal Senate: 8-year term, elections are staggered

Head of state and Government

  • President Michel Temer (acting)

Country risk assessment

Dilma’s fall from grace

Until recently, the centre-left Workers’ Party (PT) dominated politics in Brazil. Under its rule, the country saw an unprecedented reduction in inequality and especially poverty rates, with tens of millions escaping poverty to join the lower middle class. The strong socio-economic record fostered a period of relative political stability, only now and then disrupted by cases of corruption or cabinet reshuffles to ensure coalition partner support. This changed during the first term of President Dilma Rousseff, who succeeded the immensely popular Luiz Inácio Lula da Silva in 2011.

As the economy slowed down, support for the PT started to wane. Discontent notably came to the fore in June 2013, when more than a million people took to the streets in cities across Brazil to denounce rising inflation, corruption, high taxes, the poor quality of public services and the steep cost of hosting major sporting events (the FIFA World Cup in 2014 and the Olympics in 2016). Rousseff thus barely managed to win a second term in the presidential election of late 2014, which highlighted a deep polarisation of public opinion along socio-economic lines. Thanks to its pro-poor policies, the PT had retained the support of the lower classes. But much of the urban middle class and especially the business community backed the Brazilian Social Democracy Party (PSDB), which many investors had hoped would bring about more pro-business policies and renewed adherence to macroeconomic orthodoxy.

Soon after the election, an ever-expanding corruption scandal involving state-owned oil company Petrobras along with ever-gloomier economic conditions caused Rousseff’s approval rating to dwindle to an all-time low. Her position as President became untenable when the alleged involvement of her mentor Lula da Silva in the Petrobras scandal compelled the Brazilian Democratic Movement Party (PMDB) – the largest bloc in Congress and the PT’s main partner – to withdraw from the governing coalition in March 2016. A disputed impeachment process against the President (for alleged violation of fiscal laws by using state bank funds to cover budget shortfalls) thus gained strength, leading to the suspension of Rousseff’s mandate in May 2016.

Continued political turmoil on the cards

While the Senate further investigates the case against Rousseff (a final verdict is due later this year, yet given the political momentum it seems rather unlikely that she will be reinstated), Vice-President Michel Temer will act as the head of government. Reflecting the break between his PMDB and the PT of Rousseff, Temer has set up a caretaker government with a pro-business agenda and support from various parties previously in opposition as well as the private sector.

Yet despite initial market enthusiasm for the new government, its political position is clearly very vulnerable. For one thing, the electoral court is still investigating allegations that Rousseff and Temer used funds that originated from corruption to finance their 2014 election campaign. The results of this investigation may not come until 2017, but could eventually lead to Temer’s removal from the presidency. Moreover, securing a congressional majority to pass austerity measures may become increasingly difficult as elections draw near and popular discontent grows. This would come on top of public outrage over the lack of democratic legitimacy of the new administration and over the appointment (and subsequent resignation) of ministers under investigation in the Petrobras scandal. In any case, it is clear that politics will continue to be dysfunctional for some time to come. As such, Brazil will likely remain deprived of the effective policy-making it so desperately needs to revive investor confidence and address its economic woes.

From economic boom to bust

Until the start of an economic slowdown in early 2011, international as well as domestic conditions contributed to a success story. On the external front, Brazil benefited from benign terms of trade and favourable access to credit, the former as Chinese demand caused commodity prices to boom and the latter indicating international investor confidence in the Brazilian ‘holy trinity’ macroeconomic policy framework of a floating exchange rate (introduced after the devaluation that ended the balance of payments crisis of 1999), inflation-targeting and well-managed public finances (both established as part of the ‘Plano Real’, which effectively addressed the period of hyper-inflation in the early 1990s). Strong household consumption constituted the main domestic growth driver, as it was supported by credit expansion and by redistributive measures introduced by the Lula da Silva administration such as increases in the minimum wage, the ‘Bolsa Família’ programme of conditional cash transfers to poor families and a non-contributory pension scheme.

However, weak external demand (as a result of slower growth in China, modest recovery in the USA and the crisis in the eurozone) and the unwinding of the commodity boom made for a growth slowdown from early 2011. Despite accommodative monetary and fiscal policies, a rebound failed to materialise. Real GDP growth fell from 7.5% in 2010 to 3.9% in 2011 and 1.9% in 2012. After a modest uptick in 2013, economic activity virtually stagnated in 2014. And since then, the situation has become much worse rather than better. Real GDP contracted by 3.8% in 2015, as domestic woes added to external ones. For one thing, consumer spending – a main growth driver during the boom and resilient until recently – has lost strength as rising unemployment, disappointing wage hikes, already-high indebtedness and climbing interest rates have depressed household confidence.

Investor confidence has suffered as well, not least owing to soaring inflation. The annual evolution of prices has been close to the upper band of the 2.5%-6.5% central bank target range since 2010, but more recently it surpassed that ceiling because of a long-overdue upward adjustment of regulated prices (for fuel, electricity, etc.) and because a marked depreciation of the Brazilian real rendered imports more expensive. Thus, 10.7% inflation was recorded in 2015, the highest level since 2003. Strikingly, that is despite an on-going sharp contraction of monetary policy. Since March 2013, the central bank has raised its policy interest rate from 7.25% to 14.25%, thus signalling a renewed commitment to inflation targeting in line with the ‘holy trinity’ macroeconomic framework and reducing policy uncertainty. Indeed, inflation is set to drop to 7.1% this year and 6.0% in 2017.

Fiscal woes are mounting… but unlikely to affect the Olympics

Contrary to monetary policy, the fiscal stance remained accommodative until fairly recently. Notably, targets laid down in the fiscal responsibility law have not been met, thus undermining that pillar of the ‘holy trinity’ and further eroding confidence. As the primary balance worsened from a surplus of 2.9% of GDP in 2011 to a deficit of 1.9% in 2015, general government debt increased from around 61% to a rather high 74% of GDP over the same period (though to the benefit of external solvency, some 80% of the debt is held domestically).

The deterioration of public finances is also evident at sub-sovereign level. Notably, the acting governor of the State of Rio de Janeiro recently declared a fiscal emergency, warning that the crisis could result in a ‘total collapse in public security, health, education, mobility and environmental management’. Concerned about the fallout for the Olympics (due to start in Rio on 5 August 2016), acting President Temer responded by pledging an additional USD 855 million in federal funds for Rio. Yet while these should allow it to meet its most urgent liquidity needs, addressing solvency concerns will require more structural policy initiatives. And that is the case not only for Rio. Indeed, due to the on-going economic crisis in Brazil (which has undermined tax revenues) and because refinancing options (at reasonable cost) have become scarcer, there is growing consensus that a significant share of sub-sovereign debt owed to the central government (which is the main creditor for many sub-sovereign entities) has become unsustainable. Negotiations on the subject are on-going, but no agreement on any definitive debt restructuring has so far been reached. The question moreover remains how feasible such an agreement is, primarily because any debt relief benefiting the States would further hurt the already-troubled financial position of the central government.

The way out of crisis hinges on resolving the confidence crisis

With the Brazilian economy increasingly in the doldrums, the idea that the domestic growth model needs structural change has been gaining ground. In this context, the new government of acting President Temer has focused on restoring policy credibility. In the field of monetary policy, the commitment to inflation-targeting was confirmed by the appointment of a new Central Bank governor and by expanding the autonomy of the institution (granting it full independence may be on the cards). As for fiscal policy – contrary to what the announced public sector primary deficit of 2.7% of GDP may signal – a laudable consolidation effort is under way. In particular, the new finance minister is ambitiously aiming to reform the generous pension system as well as the fiscal rule regarding the indexation of government expenditure. That said, since a 60% legislative majority is needed to pass the related amendments, it remains to be seen whether the measures will ultimately stand. In any case, some form of austerity is on the cards, which is likely to improve the medium-term outlook but aggravate the economic downturn in the short term. That is why such a pro-cyclical policy stance would usually be considered misguided. The authorities in Brazil have little choice, however, since a further deterioration of public finances would restrict access to international financial markets, a consequence the country can ill afford.

This clearly restricts the scope for growth-supporting measures. Basically, all the government can do is attempt to alleviate supply-side constraints in the hope that this will boost private-sector confidence. If that happens, it could herald a rebalancing from consumption to investment-led growth. That is much needed, because subdued investment is currently undermining the potential for growth. Note that in 2015, investment represented less than 20% of Brazilian GDP, while the ratio easily exceeded that threshold in countries such as Chile, Colombia and Mexico.

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In line with these observations, the IMF expects another year of recession before activity gradually starts to pick up from 2017. In concrete terms, real GDP is set to contract by 3.3% in 2016 and to grow by 0.5% next year. Yet even this measly forecast is subject to significant downside risk. Indeed, much uncertainty prevails with regard to the assumed implementation of structural reforms, the rebound in household and investor confidence and the evolution of the exchange rate, commodity prices and external financing conditions. Moreover, the impact of the Petrobras scandal may still deepen as investigations advance. Already, the oil company has seen its access to financial markets impaired, which has driven it to cut back significantly on capital spending (thus further depressing domestic investment) and sell foreign assets.

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Currency depreciation alone will not restore competitiveness

Unsurprisingly, the economic downturn in Brazil has also affected its external position. The current account balance has been negative since 2008, and the deficit has widened markedly in the years since then. Due to resilient import demand (for consumption goods in particular), subdued external demand (exacerbated by a crisis in Argentina), softer terms of trade (with lower prices for oil, iron ore and soy) and impaired competitiveness, the deficit intensified from 1.6% of GDP in 2009 (14% of current account receipts) to 4.3% of GDP in 2014 (37% of current account receipts).

Even though current account receipts have further declined since then (they have dropped by almost 30% over the past five years), that does seem to have been the low point. Indeed, as import demand dampened and Brazil benefited from low oil prices (despite significant own production, the country is a net fuel importer), the external deficit moderated to 3.3% of GDP in 2015 (still about 25% of current account receipts) and stands to decline to 2.0% in 2016 (less than 14% of current account receipts) and 1.0% in 2018 (less than 7% of current account receipts). Note that apart from import dynamics, this forecast also reflects the assumptions that the weaker exchange rate will boost exports and that Brazil will start to benefit from an improved oil trade balance as pre-salt production and refinery capacity are expanded.

A more fundamental improvement of the external position would require measures to do away with structural impediments to competitiveness, however. Tellingly, the term ‘Brazil cost’ refers to subpar infrastructure, bureaucratic red tape, tax system complexity, inadequate access to credit and high unit labour costs (among other things explained by high minimum wages). The concern is well illustrated by the fact that manufactured goods represented over 70% of goods exports until 2006, but barely more than 50% in 2015. Diversification thus declined, as opposed to commodity dependence.

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Yet despite all these concerns, capital flows into Brazil have stayed relatively robust: net foreign direct investment inflows have averaged 3% of GDP since 2012 (and in 2015 even fully covered the current account deficit) while portfolio inflows have rebounded from a dip in 2012 (thanks to higher central bank interest rates and the undoing of a capital inflows tax). That said, the Brazilian real has been among the emerging market currencies most affected by the recent bouts of financial market volatility. In fact, since peaking in July 2011, it has lost some 45% against the US dollar. Despite the clear benefits that such important currency depreciation may have for external competitiveness, concerns about import-driven inflation have compelled the authorities to support the real. While this has created some uncertainty about exchange rate flexibility serving as a first buffer against external shocks – the final pillar of the Brazilian macroeconomic ‘holy trinity’ – policy makers have recently scaled down interventions to reassure markets.

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Rising external debt… but huge buffers mitigate the liquidity risk

External indebtedness followed a downward trend until 2008, when it represented 119% of current account receipts (some 17% of GDP). Since then, two economic downturns and the associated weak export performances along with a sharp increase in private-sector debt have vastly driven up these ratios. By the end of 2015 total external debt stood at a very high 280% of current account receipts (almost 38% of GDP). Moreover, with the current account expected to remain in deficit, the forecast is for external debt to reach nearly 300% of current account receipts by the end of this year. That implies significant risk.

The increasing importance of foreign exchange denominated debt issuance has allowed corporates to access credit at longer maturities and lower rates. That said, it has also made for mounting external debt service obligations. Expressed as a share of current account receipts, these rose from 16% in 2011 (when they hit a low) to around 49% in 2015. And while they are likely to moderate somewhat in the years to come, the ratio is expected to remain high, at around 40%.

In terms of international reserves, Brazil still enjoys the vast liquidity buffer that was built up in the 2000s. As of the end of April 2016, reserves covered the equivalent of more than 16 months of goods and services imports, the standard threshold being 3. Reserves still amount to 52% of the total external debt, and are 4.5 times the short-term debt and more than 3 times the annual debt service.

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