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Recession, high rates doomed Brazil’s S&P rating
BLOOMBERG INTELLIGENCE SEPTEMBER 11, 2015
This analysis is by Bloomberg Intelligence economist Marco Maciel. It originally appeared on the Bloomberg Professional service.
Two major reasons led Standard & Poor’s to lower its rating on Brazil’s sovereign debt to junk status Wednesday: the recession, which could be more severe and lengthy than anticipated, and the related fiscal deterioration. S&P’s action came faster than the market had expected — investors were looking to 2016 — and left the door open to more ratings cuts.
The agency’s decision to maintain a negative outlook for Brazil’s sovereign risk means there is a one in three chance of another S&P downgrade in the short term, probably next year. The other two major rating agencies — Fitch and Moody’s — have maintained Brazil’s rating at investment-grade level, but in Bloomberg Economics’ view are likely to follow S&P’s decision shortly.
Deeper and longer recession would jeopardize tax revenues in 2015 and 2016. That would bring the public primary budget balance (that is, before interest payments) below the revised target for 2015 (a meager 0.15 percent of GDP surplus) and in line with or below the negative scenario for 2016 (an expected deficit of 0.5 percent of GDP as outlined in next year’s Fiscal Budget Law). In fact, S&P currently projects an increase in the total government deficit — the general government expected primary balance plus debt servicing — to 8 percent of GDP both this year and in 2016.
The stability of the base interest rate at 14.25 percent throughout at least the first half of 2016 and the government’s projected primary deficit of R$30 billion next year are major underpinnings for S&P’s stance on the path of the national debt service requirements and for its rating downgrade. As a result of the deficit, and as our own simulations suggest, the ratio of public-sector gross debt to GDP would escalate to the neighborhood of 70 percent in 2016 from the current level of 64.6 percent.
In order to generate the simulations in our debt/GDP chart, our debt sustainability model incorporates the government targets for the primary balance between 2015 and 2018, a conservative view for real GDP growth consistent with the S&P statement and a trajectory for the average cost of debt service closely correlated with the base interest rate path expected for the period. The model suggests that the government’s fiscal task won’t be easy between 2016 and 2018 as the path of the gross debt/GDP ratio presents the risk of high instability.
The changing levels for parameters in the table below make clear the sources of this instability. They also show how important real GDP growth is, not only for the generation of tax revenues but also for meeting a credible primary balance target. Finally, notice that the trajectory of the gross debt/GDP ratio depends on the public debt’s average cost, which — under normal circumstances — would follow market trends for the central bank base rate expected for the period between 2015 and 2018. Before the S&P rating revision, financial market expectations had been for this rate to fall, especially from the second half of 2016.
After examining the context of S&P’s rating cut, one should no longer expect a strong correlation of the average cost of the public debt with the base interest rate (see the chart below). In fact, Brazil’s five-year CDS are likely to remain at relatively high levels, and consequently the Brazilian real should continue relatively depreciated compared to the dollar and to the currency basket. The spread between the tenor of the interest rate term structure curve (maturing mainly after January 2017) and the short-term Selic base rate could rise in the short run. This naturally would result in a higher average cost of public debt.
For instance, should the interest rate term structure curve steepen in the near future and therefore if the spread between the public debt average cost and the base rate rises 30 basis points throughout the coming months, the public debt/GDP ratio would escalate to 71 percent, 72.6 percent and then almost 74 percent in 2016, 2017 and 2018, respectively.
S&P also took into account the political instability of the legislative and executive branches in its decision. Surely, it is very difficult to count on the national Congress to enact structural measures that would reduce non-discretionary expenses.
On the other hand, cuts in discretionary expenses, which act as stimulants to the economy, would certainly reduce Brazil’s potential GDP growth. Amid the loss of Brazil’s sovereign investment grade and given the tumbling popularity of President Dilma Rousseff, it is also almost impossible to imagine a government coalition that would be able to sustain a long-term and structural fiscal adjustment through cuts in expenses combined with tax hikes, despite Finance Minister Joaquim Levy’s suggestion the latter may become necessary.
Of course, the sustainability of Brazilian debt would worsen and the vicious narrative would start again under yet more stress to the currency and inflation. For instance, a BRL quote persistently above 4.0/USD (which would be consistent with Brazil five-year CDS above 400 basis points), naturally characterized by annual volatility levels close to 40 percent, would produce expected inflation rates next year above the current projected level (in the vicinity of 5.5 percent) and lead to downward revisions on forecasts of Brazil’s shrinking GDP. We will leave the elaboration of this exercise for another sad chapter.
Recession, high rates doomed Brazil's S&P rating | Economic Research, Economics | Bloomberg Professional
BLOOMBERG INTELLIGENCE SEPTEMBER 11, 2015
This analysis is by Bloomberg Intelligence economist Marco Maciel. It originally appeared on the Bloomberg Professional service.
Two major reasons led Standard & Poor’s to lower its rating on Brazil’s sovereign debt to junk status Wednesday: the recession, which could be more severe and lengthy than anticipated, and the related fiscal deterioration. S&P’s action came faster than the market had expected — investors were looking to 2016 — and left the door open to more ratings cuts.
The agency’s decision to maintain a negative outlook for Brazil’s sovereign risk means there is a one in three chance of another S&P downgrade in the short term, probably next year. The other two major rating agencies — Fitch and Moody’s — have maintained Brazil’s rating at investment-grade level, but in Bloomberg Economics’ view are likely to follow S&P’s decision shortly.
Deeper and longer recession would jeopardize tax revenues in 2015 and 2016. That would bring the public primary budget balance (that is, before interest payments) below the revised target for 2015 (a meager 0.15 percent of GDP surplus) and in line with or below the negative scenario for 2016 (an expected deficit of 0.5 percent of GDP as outlined in next year’s Fiscal Budget Law). In fact, S&P currently projects an increase in the total government deficit — the general government expected primary balance plus debt servicing — to 8 percent of GDP both this year and in 2016.
The stability of the base interest rate at 14.25 percent throughout at least the first half of 2016 and the government’s projected primary deficit of R$30 billion next year are major underpinnings for S&P’s stance on the path of the national debt service requirements and for its rating downgrade. As a result of the deficit, and as our own simulations suggest, the ratio of public-sector gross debt to GDP would escalate to the neighborhood of 70 percent in 2016 from the current level of 64.6 percent.
In order to generate the simulations in our debt/GDP chart, our debt sustainability model incorporates the government targets for the primary balance between 2015 and 2018, a conservative view for real GDP growth consistent with the S&P statement and a trajectory for the average cost of debt service closely correlated with the base interest rate path expected for the period. The model suggests that the government’s fiscal task won’t be easy between 2016 and 2018 as the path of the gross debt/GDP ratio presents the risk of high instability.
The changing levels for parameters in the table below make clear the sources of this instability. They also show how important real GDP growth is, not only for the generation of tax revenues but also for meeting a credible primary balance target. Finally, notice that the trajectory of the gross debt/GDP ratio depends on the public debt’s average cost, which — under normal circumstances — would follow market trends for the central bank base rate expected for the period between 2015 and 2018. Before the S&P rating revision, financial market expectations had been for this rate to fall, especially from the second half of 2016.
After examining the context of S&P’s rating cut, one should no longer expect a strong correlation of the average cost of the public debt with the base interest rate (see the chart below). In fact, Brazil’s five-year CDS are likely to remain at relatively high levels, and consequently the Brazilian real should continue relatively depreciated compared to the dollar and to the currency basket. The spread between the tenor of the interest rate term structure curve (maturing mainly after January 2017) and the short-term Selic base rate could rise in the short run. This naturally would result in a higher average cost of public debt.
For instance, should the interest rate term structure curve steepen in the near future and therefore if the spread between the public debt average cost and the base rate rises 30 basis points throughout the coming months, the public debt/GDP ratio would escalate to 71 percent, 72.6 percent and then almost 74 percent in 2016, 2017 and 2018, respectively.
S&P also took into account the political instability of the legislative and executive branches in its decision. Surely, it is very difficult to count on the national Congress to enact structural measures that would reduce non-discretionary expenses.
On the other hand, cuts in discretionary expenses, which act as stimulants to the economy, would certainly reduce Brazil’s potential GDP growth. Amid the loss of Brazil’s sovereign investment grade and given the tumbling popularity of President Dilma Rousseff, it is also almost impossible to imagine a government coalition that would be able to sustain a long-term and structural fiscal adjustment through cuts in expenses combined with tax hikes, despite Finance Minister Joaquim Levy’s suggestion the latter may become necessary.
Of course, the sustainability of Brazilian debt would worsen and the vicious narrative would start again under yet more stress to the currency and inflation. For instance, a BRL quote persistently above 4.0/USD (which would be consistent with Brazil five-year CDS above 400 basis points), naturally characterized by annual volatility levels close to 40 percent, would produce expected inflation rates next year above the current projected level (in the vicinity of 5.5 percent) and lead to downward revisions on forecasts of Brazil’s shrinking GDP. We will leave the elaboration of this exercise for another sad chapter.
Recession, high rates doomed Brazil's S&P rating | Economic Research, Economics | Bloomberg Professional