Overview

• The pandemic has exacerbated some of Brazil's key structural weaknesses, primarily low economic growth, large fiscal imbalances, and a high government debt burden.
• The country's fiscal reform agenda has evolved slowly, while larger fiscal deficits are exerting funding pressures on the government.
• We are affirming our 'BB-/B' sovereign credit ratings on Brazil.
• The stable outlook indicates that we assume timely implementation of fiscal adjustment and modest economic recovery will help preserve market confidence and adequate funding conditions for the government in local markets in the next two years, despite a sustained increase in the debt burden.

Rating Action

On Dec. 10, 2020, S&P Global Ratings affirmed its 'BB-/B' long- and short-term foreign and local currency sovereign credit ratings on Brazil. The outlook on the long-term ratings remains stable. We also affirmed our 'brAAA' national scale rating, and the outlook remains stable. The transfer and convertibility assessment on Brazil is still 'BB+'.

Outlook

The stable outlook assumes that timely implementation of fiscal adjustment and modest economic recovery will help preserve market confidence and adequate funding conditions for the government in local markets in the next two years, despite a sustained increase in the debt burden.

Persistent fiscal weakness over the same timeframe, as a result of poor growth or sluggish policy reaction, could translate into further financing pressures for the government. This could lead to lower ratings, in particular if it reduces the commitment from the political class toward fiscal consolidation.

Conversely, we could raise the ratings if Brazil's fiscal performance improves more than we expect over the forecast. This could come from stronger growth and advancement from stalled structural fiscal reforms.

Rationale

The government deficit has widened significantly in 2020 as a result of the large fiscal support to the economy and GDP contraction. Moving into 2021, as activity gradually rebounds, Brazil faces the significant challenge of unwinding fiscal stimulus measures implemented this year. The failure to implement timely adjustments in the next year could further erode market confidence locally and financing conditions for the government.

Brazil's strong external position, proactive monetary policy, floating exchange rate, and favorable sovereign debt composition constitute relative credit strengths that should enable it to address the difficult conditions.

Institutional and economic profile: Progress on fiscal legislation becomes even more pressing given Brazil's larger financing needs and moderate growth prospects

• After a 4.7% contraction in 2020, we expect economic growth to rebound in 2021, although the removal of fiscal stimulus will create uncertainty.
• The legislative agenda is crowded, and the window for discussion during the rest of the administration is tight.
• Continued delays in advancing structural reforms hurt the sovereign's fiscal credibility.

The economic recovery gained strength during the third quarter after sharp declines in April and May, although some signs of slowdown began to appear. We now believe that GDP will contract 4.7% in 2020 and expand 3.2% in 2021.

The Brazilian authorities have introduced extraordinary support to mitigate the economic, social, and financial impact of the pandemic. The full fiscal support package is 12% of GDP, one of the largest among emerging markets, of which the direct impact in the 2020 government primary deficit is estimated around 8% of GDP. The bulk of the measures is an emergency aid program, equivalent to 4.5% of GDP, which has benefited more than 60 million people.

The upcoming expiration of these measures raises uncertainty about the pace of recovery next year, putting pressure on policymakers to approve an extension of the benefits despite the lack of fiscal space.

We expect a sustained, although moderate, recovery in private investment in the coming quarters due to the expansionary monetary policy, the SELIC benchmark rate at a record low of 2%, and a strong increase in capacity utilization according to recent surveys. Moreover, the approval of microeconomic reforms in a number of sectors--recent examples include the passage of new legislations on sanitation and bankruptcy--and a large program of concessions bode well for investment prospects. On the other hand, persistent fiscal uncertainty and high government financing needs could hurt business confidence.

Brazil's growth prospects have been below those of other countries at a similar stage of development, in our view. We expect GDP per capita of US$6,513 for 2020. Raising the country's long-term GDP growth depends on reforms to increase productivity and private investment, such as a simplification of Brazil's cumbersome tax rules (discussion on this is in an advanced stage in Congress). A slower pace of economic recovery next year could result in less favorable political conditions for passing difficult economic 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 and the pandemic have posed a challenge in moving ahead more swiftly on the economic and fiscal agenda, in particular because several reforms require constitutional amendments (PECs, by their Portuguese acronym). In the near term, a legislative priority is the approval of a fiscal reform, which would seek to address the pressing issue of a potential breach of the constitutional spending cap (which caps public spending growth at the previous year's inflation rate).

Municipal elections last November and the upcoming election of the leaders of the Chamber of Deputies and the Senate (in February 2021) have further delayed difficult political negotiations that are becoming even more urgent given market concerns over increasing fiscal risks. The window for approval of a crowded agenda of reforms is very tight with the 2022 presidential election on the horizon. We expect political dynamics to remain fluid in the coming quarters, especially if growth disappoints.

Flexibility and performance profile: Large fiscal deficits will increase the debt burden but risks are offset by Brazil's resilient external position

• Brazil is expected to post significant deficits in the next two years.
• Prolonged fiscal uncertainty could fuel market concerns, complicating debt management.
• In this environment, moderate current account deficits and limited external borrowing will sustain the country's creditworthiness.

The large policy response to the pandemic will worsen Brazil's already weak fiscal performance. We expect the change in net general government debt to spike to about 16% of GDP in 2020 and recede to 8% in 2021. The fiscal deficits will increase the government's net debt burden to about 76% of GDP by the end of 2021, and continue to increase over the forecast, reaching almost 80% of GDP in 2023.

Extraordinary revenues, including additional transfers from the central bank, state bank BNDES, and other public banks, as well as proceeds from privatizations, could help marginally reduce the debt burden. On the other hand, a record-low SELIC has helped reduce government borrowing costs and interest payments. We expect borrowing costs and interest payments to continue to decline toward 12% of government revenues in the next three years. However, this assumption is subject to inflation expectations remaining anchored in the medium term. Signs of rising inflation have been mounting in recent months due to the passthrough of the weaker exchange rate to food prices. We expect inflation to average 3.5% in 2020-2023, within the central bank targets.

A favorable composition of debt, large government liquid assets (around 16% of GDP), and limited contingent liabilities mitigate the risks of managing Brazil's high debt burden. The National Treasury has used part of its cash cushion to fund its larger financing needs in the context of the pandemic, but transfers from the central bank have helped to mitigate the fall in government assets. Government debt remains overwhelmingly in local currency (foreign currency only represents 5.7% of the total). The share of nonresident holdings of government securities has been declining, reaching 10% of the total as of October 2020 (compared with 19% in December 2015). Nevertheless, the rapid buildup in debt, the prospect of large financing needs next year (28% of the outstanding debt will mature in next 12 months), and slow progress in passing structural reforms have increased domestic market concerns in recent months, leading to a sharp steepening of the local currency yield curve and, consequently, shortening maturities.

In a context of demands for more spending next year on extended social programs, a breach of the spending cap--without a defined and credible plan for fiscal adjustment in the medium term--could erode fiscal credibility and deteriorate funding conditions for the government.

The country's external profile has remained resilient in recent years despite frequent episodes of global volatility. The Brazilian real floats and is an actively traded currency. The country has been in a narrow net external creditor position since 2016 as a result of limited public and private external borrowing combined with a large stock of international reserves. We project this trend to continue in the coming three years (narrow net external debt at -12% of current account receipts on average).

Despite this favorable external debt position, we consider that Brazil could be vulnerable to sudden changes in foreign direct investment (FDI) flows, since net external liabilities, which include the high stock of FDI in the country, account for almost 200% of current account receipts in 2020. Despite a drop in inflows this year, we expect net FDI to remain the largest source of financing of the current account deficits (CADs). We assume the CAD will slowly increase in the coming years, as imports and profit distribution accelerate, but remain below 2% of GDP, consistent with an only mild recovery in domestic demand.

The central bank has provided ample monetary policy and liquidity support during the pandemic. The SELIC rate was cut by 225 basis points to 2%, and the central bank has adopted a new communication tool of forward guidance. The central bank has also been able to advance on several initiatives included in its multidimensional BC# agenda, which, along with the very low rates in Brazil, is supporting the development of local financial markets.

Positively, the central bank is moving toward formal autonomy. The bill proposal, approved in the Senate, establishes fixed terms of four years for the board members that do not coincide with the presidential term. In our opinion, the enhanced framework could further strengthen the credibility of monetary policy. Dealing with inflationary pressures, if the economy were to recover more rapidly than expected, could be a good test of the new monetary framework.

Key Statistics

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Ratings Score Snapshot

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Related Criteria

• General Criteria: Methodology For National And Regional Scale Credit Ratings, June 25, 2018
• Criteria | Governments | Sovereigns: Sovereign Rating Methodology, Dec. 18, 2017
• General Criteria: Methodology For Linking Long-Term And Short-Term Ratings, April 7, 2017
• General Criteria: Principles Of Credit Ratings, Feb. 16, 2011
• General Criteria: Methodology: Criteria For Determining Transfer And Convertibility Assessments, May 18, 2009

Related Research

• Sovereign Ratings History, Dec. 10, 2020
• Global Credit Outlook 2021: Back On Track?, Dec. 3, 2020
• Credit Conditions Emerging Markets: A Vaccine Won't Erase All Risks, Dec. 3, 2020
• Sovereigns: Are More Defaults Inevitable?, Dec. 3, 2020
• Sovereigns: How To Recoup The Cost Of COVID, Dec. 3, 2020
• Sovereign Ratings Score Snapshot, Dec. 3, 2020
• Latin America's Economic Recovery From The Pandemic Will Be Highly Vulnerable To Setbacks, Dec. 1, 2020
• LatAm Financial Institutions Monitor 3Q2020: Climbing Out Of A Deep Plunge, Oct. 21, 2020
• Sovereign Risk Indicators tool at spratings.com/sri
• The Key Sovereign Rating Considerations For Brazil Amid COVID-19, Sept, 18, 2020
• Banking Industry Country Risk Assessment: Brazil, June 22, 2020
• Brazil Outlook Revised To Stable From Positive On Uncertainty Related To COVID-19; 'BB-/B' Ratings Affirmed, April 6, 2020

In accordance with our relevant policies and procedures, the Rating Committee was composed of analysts that are qualified to vote in the committee, with sufficient experience to convey the appropriate level of knowledge and understanding of the methodology applicable (see 'Related Criteria And Research'). At the onset of the committee, the chair confirmed that the information provided to the Rating Committee by the primary analyst had been distributed in a timely manner and was sufficient for Committee members to make an informed decision.

After the primary analyst gave opening remarks and explained the recommendation, the Committee discussed key rating factors and critical issues in accordance with the relevant criteria. Qualitative and quantitative risk factors were considered and discussed, looking at track-record and forecasts.

The committee's assessment of the key rating factors is reflected in the Ratings Score Snapshot above.

The chair ensured every voting member was given the opportunity to articulate his/her opinion. The chair or designee reviewed the draft report to ensure consistency with the Committee decision. The views and the decision of the rating committee are summarized in the above rationale and outlook. The weighting of all rating factors is described in the methodology used in this rating action (see 'Related Criteria And Research').

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