Manolis Davradakis, senior economist at AXA Investment Managers, discusses the recent downgrading of Brazil and argues that more downgrades are in the pipeline for the country that could result in Brazil exiting hard currency investment grade debt indices and trigger sovereign downgrades for other emerging markets (EM) that are currently at the brink, like Turkey.
Standard and Poor’s (S&P) decided on 9 September to downgrade the sovereign rating of Brazil to BB+ from BBB- with a negative outlook.
The ratings agency cited political challenges that will weigh on the government’s ability, and willingness, to deliver the fiscal adjustment signalled at the beginning of the year, shortly after the renewal of Dilma Roussef’s presidential term.
Specifically, the agency points to the government’s recent revision of the 2016 budget, six weeks after a revision to the fiscal target.
The ratings downgrade from S&P came as a surprise and the Brazilian real (BRL) lost 1% of its value relative to the dollar at market close on 9 September. That surprise related to two factors.
First, Moody’s (and not S&P) was the prime suspect to trigger a sovereign downgrade, given that Moody’s was the only rating agency holding Brazil two notches above investment grade with a negative outlook.
Second, the timing of the rating action was surprising, coming shortly after the government submitted its 2016 budget proposal to Congress, without waiting for the budgetary execution.
Yet what ultimately informed the sovereign downgrade was the consecutive downward revision in the primary surplus targets for 2016 from 2% at the beginning of the year to the 0.7% of GDP in July, and -0.3% of GDP in late August.
This reflected a combination of shortfalls in delivering policy adjustment, and the underperformance of revenues due to the deeper recession expected in 2015 (which is having a significant negative carry over effect to 2016).
The dire fiscal performance is better illustrated in the decline of the average primary surplus, which collapsed from 3.6% of GDP in 2003-05 to 1.8% in 2012-14 and -0.7% in 2015. Already the 2016 budget pencils in, for the first time, three years of primary deficits from 2015-2017.
There is a growing risk of a growing risk of further sovereign downgrades for Brazil as the economy is trapped in a negative feedback loop, where the political crisis hampers a confidence-enhancing fiscal adjustment, which deepens the country’s existing recession due to falling commodity prices.
The recession expected in 2015 and 2016 (real GDP growth at -3.5% and -0.9% in 2015 and 2016, respectively) will challenge the budgetary execution and consequently, debt sustainability.
The risks to this growth outlook are to the downside as the impact of the prolonged tightening cycle of the central bank has not been fully transmitted to economic activity, due to the long lags in monetary policy transmission (almost two years).
Already the Brazilian central bank has decided to stop tightening due to the deepening recession. Political uncertainty will also weigh on the budgetary execution.
The judicial probe on the Petrobras scandal also continues, revealing that Petrobras executives were using the currency exchange and money wiring services of a car wash station in Brasilia to transfer money from the oil company into overseas bank accounts. Brazilian newspapers are circulating rumours for an impeachment of President Roussef, fuelling even further political uncertainty.
Debt sustainability will be further challenged by the expected normalisation of US monetary policy, which will result in higher interest rates in the EM space in general. Public debt is projected to increase from 58.9% of GDP in 2014 to 65.5% in 2015, and 68.4% in 2016 before it reverts to 68.2% in 2018 and 67.3% in 2019.
It is almost certain that the BRL will continue depreciating as there is a very strong correlation between the currency and the 5-year sovereign CDS, a proxy for market concerns, which has been impacted by budgetary execution, threatened by deepening recession and political uncertainty.
Risk of downgrades for other EMs
Brazil is still included in the JP Morgan EMBI Global Diversified IG Index, where eligible securities must be deemed investment grade by any two of the rating agencies, and it has the fourth largest weighting (6%) behind China, Mexico and Turkey.
Currently Brazil’s sovereign rating stands at – Moody’s: Baa3 (outlook stable), Standard and Poor’s: BB+ (outlook negative), and Fitch: BBB (outlook negative).
We anticipate that either Moody’s or Fitch may jump on the gun and downgrade Brazil below investment grade due to poor budgetary execution, challenges to debt sustainability and political uncertainty.
Subsequently, the country would exit the JP Morgan EMBI Global Diversified IG Index as it would not have the required two investment grade ratings.
In normal circumstances, Brazil exiting the index would have resulted in portfolio rebalancing from EM investors, benefitting other EMs in the index.
Yet, the mix of looming US monetary policy normalisation, weak commodity prices and concerns over China and Brazil, weighs on the already badly-hit confidence of EM investors and would trigger more downgrades in the EM space.
Turkey’s investment grade is clearly at risk. Further downgrades would intensify EM portfolio debt outflows and ramp up total EM portfolio outflows, currently mostly attributable to EM equity portfolio outflows.