Brazil’s credit rate downgrading: Another bump on the road to recovery
IMD Professor Carlos A. Primo Braga on Brazil's S&P downgrading
September 11, 2015
The annus horribilis for the Brazilian economy seems to be going from bad to worse as time goes by. The country's worst economic recession of recent history (negative growth of at least 2% in 2015) and the never-ending corruption scandal around Petrobrás frame the current economic and political scenario. Moreover, political gridlock seems to be the main achievement of the Roussef administration in its second term. To make things worse, the external environment (Chinese economic slowdown, decline in the price of commodities, and expectations about interest rate increases in the US…) has not been kind to Brazil. The latest blow came on Thursday September 10th when Standard & Poor's (S&P) downgraded the country's credit rating to "junk" status.
The downgrade from BBB- to BB+ (with a negative outlook) means not only that Brazil has lost its cherished investment grade according to S&P, but also opens a "Pandora's box" in terms of potential investors' reactions to the creditworthiness of Brazil. The downgrade per se was not a surprise, although its timing was. The fiscal slippage (Brazilian authorities had just revised their estimates of the primary surplus for 2016 from 0.7% to – 0.34%) and the political crisis hinted that this was coming, but most analysts expected Brazil to retain its investment grade in 2015 since the country remains in a strong position in terms of its foreign reserves.
The move by S&P will increase nervousness in financial markets and, in the short-term, will foster additional speculation against the Real (which has already depreciated more than 30% this year vis-à-vis the US dollar). This, in turn, will make the job of the Brazilian Central Bank in reaching its inflation target even more difficult in the coming months. And with the incumbent President scoring approval ratings in the popularity polls below the current 9% plus annual inflation rate, this is not a pretty picture.
Three inevitable questions follow: (i) does this matter?; (ii) will it affect the costs of financing of Brazilian enterprises?; and (iii) will the decision of S&P be followed by similar decisions of the other major credit rating agencies (Moody's and Fitch)? The answers are yes, yes, and most likely.
The fact that credit ratings do matter should not be a surprise. They affect not only perceptions about a country (particularly when they involve the investment grade threshold), but also investment decisions. It is interesting to note that some luminaries of the Partido dos Trabalhadores (e.g., the ex-President Lula) are being dismissive of the relevance of the downgrade and ready to underscore the well-known failings of credit rating agencies in predicting the future. This is an exercise in denial and marketing, combined with ignorance. After all, Lula was ready to welcome the achievement of "investment grade" by Brazil in 2008 as a hallmark of the country reaching the status of a "serious country". Now, however, he dismisses the relevance of the downgrade and argues that it may lead to new austerity measures as if the "thermometer" were the cause of the "fever".
The relevance of the credit rating is magnified by the fact that many institutional investors have guidelines that constrain the amount of their portfolio that can be allocated to sub-investment grade issuers. The danger of a reallocation of portfolios leading to outflows of capital from Brazil is real. Moreover, as expected, the country downgrade has generated a domino effect impacting the credit risk of several Brazilian companies as evaluated by S&P, since credit rating agencies typically follow a decision rule that does not allow for significant divergence between the ratings of the sovereign and those of national companies. As a consequence, several Brazilian firms have also lost their investment grade and this will impact the cost of future external financing for them.
Concerning the correlation among credit rating decisions by the "big-three" (S&P, Moody's, Fitch), the news is not good for Brazil either. S&P is traditionally a first-mover, both with respect to advanced and emerging economies, in taking negative rating actions. These actions, however, are typically followed by the other agencies in the next three months.
In sum, the only potential "silver lining" in the current storm is the presumption that these external shocks may help the government to solve the current political gridlock and begin to implement effective adjustment actions. Unfortunately, at this stage the light at the end of the tunnel looks more like a train coming in the wrong direction.