S&P Downgrades Brazil: What Next?
On 9 September, S&P downgraded Brazil to BB+, a speculative rating, leaving the country on negative watch. Fitch (BBB, Outlook negative) and Moody’s (Baa3) maintain investment grade recommendations for Brazilian hard currency government debt; expectations now shift to the timing of further downgrades. Moody’s reaffirmed investment grade status on 11 August, leaving its outlook stable, while Fitch has not changed its rating since April 2011. Fitch’s negative outlook makes it the most likely candidate to downgrade in the near term.
S&P’s move is only a surprise for its timing, as Brazil’s alarming fiscal deterioration had reflected in widening spreads since May. Consensus had expected Brazil to lose its investment grade rating. At close on 9 September, Brazilian spreads were 378 over Treasuries, a level consistent with speculative sovereign markets. Pre-downgrade, Brazilian spreads were the widest of any major investment grade emerging country.
The catalyst for the move appears to be President Dilma’s proposed 2016 budget, which includes a 1% of GDP primary deficit target. S&P had said in their 28 July release that their rating was influenced by Brazil’s credible response to fiscal challenge, a view shared by investors. Caught between its electoral mandate and fiscal reality, Brazil’s leadership has hesitated to introduce clear policy direction. The resulting muddle has generated both uncertainty and increasing sovereign debt levels, with Brazil’s total fiscal debt to GDP now approaching 70%. Brazil’s proposed budget suggests a lower commitment to credible response, which may have triggered S&P’s subsequent move.
The rating agency may have been looking for progress on the revenue side of the budget, with proposals to raise income tax on financial institutions (from 15% to 20%), an amnesty program for individuals with undeclared overseas assets, and suggested end to the income on capital benefit all recently debated. Further change may be required; Brazil could reintroduce CPMF, a tax on financial transactions. At 0.38%, we note local estimates of potential revenues of R$80 billion, roughly 2.5 times the total proposed increase detailed above.
Turkey and South Africa are both markets that present cases for potential future rating agency scrutiny. As a whole, emerging market sovereign risk is below crisis levels, though the direction of change is not positive. Emerging markets now present investors with a balance of risk that is roughly mid-cycle. One challenge that may be faced by investors: the last cycle (2002-2009) saw rating agencies generally more pessimistic on emerging markets risk, while the current cycle has seen them generally more forgiving. Downgrade risk could surprise the market more severely as a result.
A Sovereign rating considers a wide range of inputs; because emerging markets are diverse, causes of rating downgrades may vary. In Turkey’s case, increasing leverage and external debt appear to have been increasing pressure on the national balance sheet. In South Africa, the government’s fiscal indiscipline has caused concern. As with Brazil, investors seem to worry that the government lacks the political capital to address the issue.
What does this mean for investors?
Historical experience suggests that a loss of investment grade status may lead to a decline in capital inflows, which will pressure both the current account and currency. The decline in flows may result in rising risk premiums, which tend to hurt valuation. A sovereign downgrade therefore presents a challenge to domestically focused, long-term investment cases. There is an exception: businesses that generate hard currency revenues against local currency costs should see profits (and valuation) rise in these situations.
Investors sometimes look through a de-rating, but with Brazil’s current fiscal deficit tracking at 4% of GDP, this feels unlikely in the present case. If another rating agency cut to a speculative rating would challenge Brazil’s membership in certain investment grade indexes. This could lead to forced institutional selling if the country’s average rating drops below investment grade. Brazil’s policymakers know that capital outflow hurts the country and makes their position more complex, so we may see efforts to protect the rating in the near future.
The situation remains fluid and we remain vigilant.
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