Following the approval of a comprehensive and revenue-neutral tax reform, Brazil has strengthened its track record of pragmatic policies, helping anchor macroeconomic stability. As a result, S&P Global Ratings raised its global scale sovereign credit ratings on Brazil to 'BB', with a stable outlook, from 'BB-' on Dec. 19, 2023. That said, historically Brazil's reform transition periods have been long, translating into delayed or even lower-than-expected economic benefits.

To assess the possible rating trajectory for the sovereign, including the possibility of it reaching investment grade ('BBB-' or higher), we compare Brazil with other relevant emerging markets and rated peers. We focus on the key constraints to its creditworthiness.

In our view, a higher sovereign rating will depend primarily on the evolution of Brazil's fiscal policy. Related to that, improvements in GDP growth prospects will also be key to an upgrade.

Weak Economic Growth And Fiscal Constraints Weigh On Brazil's Credit Quality Versus Peers

To construct our ratings, we assess the key credit factors that, in our opinion, affect a sovereign government's willingness and ability to service its financial obligations, and assign each a score on a scale from '1' (strongest) to '6' (weakest). Our key credit factors are:

• Institutional,
• Economic,
• External,
• Fiscal (fiscal performance and debt burden profile), and
• Monetary.

(For more details, please refer to "Sovereign Rating Methodology," published Dec. 18, 2017.)

Generally speaking, our ratings tend to be higher for sovereigns with strong institutions combined with wealthier and resilient economies.

Our ratings on Brazil are supported by a strong external position, flexible exchange rate, and an effective monetary policy regime. That said, Brazil emerges as particularly weaker than its 'BBB' rating category ('BBB-', 'BBB', and 'BBB+) and emerging market peers in the economic and fiscal assessments. We define emerging markets as countries that have been, or are, transitioning toward middle-income levels, with good access to global capital markets (including the sovereign, domestic corporations, and financial institutions), evolving domestic capital markets, and global economic relevance considering their economic size, population, and share in global trade.

In chart 1, each hexagon vertex represents the actual scores of Brazil and the peer average on each of the key credit factors. The smaller the area of the resulting hexagon, the stronger the sovereign creditworthiness, and vice versa.

Poor economic growth distinguishes Brazil from many of its peers. Despite recent positive GDP momentum in the past three years, Brazil will only return to its previous 2013 peak of real per capita GDP in 2024. Numerous reforms passed by Brazilian governments since 2016 have helped anchor macroeconomic stability, but have so far failed to support substantially higher growth prospects more in line with those of other emerging market economies (see chart 2).

Chart 2

Fiscal weaknesses stem from Brazil's highly rigid budget (due to a very detailed constitution granting numerous spending mandates) and its historical use of expansionary fiscal policy to boost economic growth at the downward part of the business cycle. We expect that Brazil's general government fiscal deficit will average 6% of GDP over 2023-2026. This, along with only moderate economic growth rates, results in one of the fastest-growing debt trajectories in terms of GDP (along with South Africa) among emerging market peers. We forecast Brazil's net general government debt to reach 66% of GDP (80% in gross terms) by 2026 from an estimated 57% (74%) in 2023.

Chart 3

Another factor in the country's weak fiscal profile is the large interest burden that we expect to average just below 15% of general government revenues between 2023 and 2026. Brazil's structurally high reference rates explain the large burden. Although they're mostly denominated in Brazilian reais (R$), Brazil's average maturities are low, leading to high rollover requirements.

Our view of Brazil's debt burden also takes into account its high contingent liabilities, mostly related to social security and to adverse judicial decisions that will further restrict general government fiscal flexibility over the long term.

Compared to six of the seven emerging market peers in the 'BBB' category (Hungary, Indonesia, Mexico, the Philippines, Peru, and Thailand) Brazil has weaker fiscal and debt assessments. The remaining peer, India, also has a very weak fiscal position. In addition, India has significantly lower GDP per capita levels than peers, but compensates for it with a very strong external position and a relatively mature and reformist institutional setup that have led to fast economic growth.

The Philippines and Thailand's fast-growing economies support the investment-grade ratings. Similar to Brazil, Mexico struggles to grow, but its more predictable institutional framework--with comparably fewer rigidities--anchors its investment-grade status.

Brazil's Lower-Than-Peers Economic Growth Stems From Various Structural Factors

Low historical economic growth rates are a key characteristic of Brazil's creditworthiness. Brazil shares this with most other large Latin American sovereigns. Numerous factors explain Brazil's historically low growth trajectory, but there is no consensus among academics and analysts on the main reason for this underperformance. Below are the factors that most directly affect Brazil's creditworthiness, in our opinion:

The country has relatively high perceived corruption, weak rule of law and property rights, and growing insecurity.  These issues hinder investment and growth. Institutional rigidities also include overlapping jurisdictions and a regulatory system that does not facilitate doing business.

Brazil has a large public sector that relies on high taxes but invests very little.   General government expenditure hovers near 40% of GDP, but historically low levels of investment will continue to constrain potential growth. Despite its large budget, federal government investment averaged only 0.9% of GDP annually over the last decade, underpinning strategic infrastructure shortfalls. Moreover, total investment levels in Brazil pale in comparison to most emerging markets, despite some improvements explained by an overhaul of the infrastructure concession framework and microeconomic reforms (see chart 4).

Chart 4

Despite various reforms passed in recent years, implementation is usually very gradual.   For example, the 2023 tax reform, which is designed to simplify a very complicated consumption tax system, won't fully implement the dual value-added tax (VAT) rates until 2033. The reform defined a transition period of 50 years to determine how VAT revenues are distributed between Brazilian subnational governments.

Brazil's population is aging rapidly, reducing the horizon for boosting growth through the demographic dividend.   Low labor productivity poses problems for Brazil to meet the future challenge of adverse demographic trends. Recent PISA (OECD's Programme for International Student Assessment) test results show that the quality of education has been stagnant for more than a decade. A decentralized education system with no structural improvements in sight raises the risk of continued low human productivity levels.

Brazil still is a relatively closed economy.   High tariffs and non-tariff barriers have limited competition, deterring firms from adopting technology and resulting in low productivity. While Brazil's exports have grown significantly thanks to agricultural and energy commodities, exports of manufactured goods accounted only for 7% of GDP on average over 2019-2023, highlighting the country's low participation in global manufacturing supply chains.

Chart 5

Financing costs in Brazil are high.   Interest rates have been historically higher in Brazil than in peer countries, partially because monetary policy has to deal with still high levels of price indexation in the economy (partially a legacy of the 1980s and early 1990s inflationary periods). The central government rolls over a large amount of debt--averaging 13% of GDP over the last five years--absorbing the liquidity in the market and raising interest rates for other borrowers (in an economy with a low domestic savings rate).

The banking system is also characterized by low competition, with the three largest domestic banks controlling 50%-60% of the credit portfolio in the past five years. That factor, along with a high share of earmarked loans and low recovery rates on bad loans, also increases lending costs.

Improving Brazil's Fiscal Dynamics Would Help Financial Market Conditions And Strengthen GDP Growth Potential

The path of our rating on Brazil will depend to a large extent on its fiscal prospects. Lower government debt would provide cushion to face unforeseen adverse shocks--a key characteristic of an investment-grade rating.

Improving fiscal sustainability over the next few years would also help to anchor inflation expectations and improve long-term financing conditions. Lower government financing needs would allow additional space in the domestic markets for financing for a more productive private sector. Tackling budget rigidities would open more room for higher public sector investment in strategic sectors, helping boost potential growth.

Brazil's government plans to raise taxes further to fund government spending growth while setting its fiscal result on a consolidation path, but this remains a challenging goal. The efficiency of revenue-raising measures passed since 2023 is still unproven. More importantly, the size of Brazil's general government is already very large in terms of GDP. Structural measures such as expanding the income tax base or reducing tax subsidies will likely be limited due to political considerations.

Chart 6

A credible strategy to reduce the fiscal deficit will depend on both reducing expenditures and improving their quality, including a strong commitment to tackle mandatory spending, which averaged 92% of central government primary spending in the last five years. Mandatory spending usually follows indexation rules or a link to fiscal revenue performance. The other 6% of central government primary spending is discretionary (that includes capital expenditures) and accounted for only 1.6% of GDP on average over 2019-2023.

Tackling mandatory spending requires constitutional amendments. The cumbersome political process to approve them has long been the main reason not to pursue the needed reforms to add flexibility to the government spending budget. That said, 33 of the total 132 constitutional amendments to Brazil's 1988 Constitution were approved in the past five years.

Reforms to central government personnel spending (3.3% of GDP in 2023), the pension system (8.3%), and automatic transfers to local and regional governments (LRGs; 4.2%) would have the most structural impact to mandatory spending, in our view. Debate on administrative reforms has been ongoing for years and basically aims to limit the salary progression of civil servants. Brazil passed an important pension reform in 2019 to raise the mandatory retirement age, but the pension system continues to run annual deficits (4% of GDP in 2023) amid an aging population. Future reforms are needed to boost the system's long-term sustainability.

In our opinion, LRGs are an often overlooked structural weakness of Brazil's fiscal profile. LRGs in Brazil collect over a third of general government revenues and execute about half of general government spending. LRGs' relatively balanced aggregate fiscal results in recent years have partially come at the expense of the federal government, which has provided significant support in the form of transfers or debt service support. LRGs share most of the rigidities of the federal government, and we think adding flexibility to their budgets would also add to Brazil's capacity to pursue fiscal consolidation.

Brazil's Potential Investment-Grade Status Hinges On Reducing Fiscal Vulnerabilities And Bolstering Economic Growth

The country already has strengths versus its major emerging market peers such as its well-established democratic institutions, diverse economic structure, strong external balance sheet, and growing record of macroeconomic stability, now supported by an independent central bank. Brazil attained investment-grade status in 2008 and remained there until we downgraded it in 2015. In our opinion, how quickly Brazil could regain an investment-grade rating will depend to a large extent on the political commitment to a continued economic reform process to achieve fiscal consolidation and economic growth.

Related Research

• Economic Outlook Emerging Markets Q2 2024: Growth Divergence Ahead, March 26, 2024
• Research Update: Brazil Long-Term Ratings Upgraded To 'BB' From 'BB-' Following Tax Reform Approval; Outlook Stable, Dec. 19, 2023