Brazil's Massive Confidence Crisis

"For a country hosting the 2016 summer Olympics, the image of Brazil should be one of hope and glory, not malaise and dashed dreams."

Brazil is undergoing a crisis of confidence. Latin America’s largest economy is a long distance from another debt debacle akin to the 1980s, but dark clouds cover the landscape. President Dilma Rousseff's administration is deeply troubled by a scandal at the state-owned oil company Petrobras; there are ongoing calls for her impeachment and periodic demonstrations in the street; and the economy is slipping deeper into recession.

Brazil’s real GDP for 2015 is now expected to see a contraction of a little over 2.0 percent, inflation remains high and the fiscal deficit is hovering around 6.0 percent of GDP and awaiting new spending cuts. Furthermore, according to Bloomberg, 2015's sell-off in the Brazilian stock exchange has seen $600 billion of valuation disappear and the country’s currency, the real, is one of the world’s worst performing, having depreciated over the past year nearly 40 percent against the U.S. dollar.

To top things off, on September 9, Standard & Poor's rating agency took down the country's sovereign rating from investment to noninvestment grade, an action that is likely to trim international investment flows into Latin America's largest economy. The root cause is a growing fiscal problem and what increasingly appears to be a degree of dissension over policies. The rating agency left a negative outlook for the country’s prospects, suggesting that its ratings could fall further.

There is also discussion that the two other large ratings agencies, Moody’s and Fitch, may follow suit with downgrades in the months ahead. Although the significance of credit ratings should not be overstressed, reaching investment-grade standing was seen as a validation that Latin America’s largest economy was on the march to a better future. Indeed, some have said that gaining investment-grade ratings indicated that Brazil was a “serious country.” Hence, the loss of one of three ratings is observed as a blow to the nation’s confidence.

Brazil is an important bellwether for much of the Emerging Markets, and Latin America in particular. The country remains dependent on commodity exports, which did very well during the commodities supercycle. The strong Chinese economic expansion of much of the last two decades and the related need to upgrade national infrastructure in such areas as trains, ports and roads translated into greater demand for Brazilian iron ore, steel and other commodities, including food.

Fast-paced Chinese growth now appears over and demand for Brazilian goods has plummeted. At the same time, important reforms that might have diversified the economy, added efficiencies and made state finances leaner faltered under Rousseff’s first term, which commenced in 2011.

While Brazil grapples with its reliance on commodity exports, prospects for rising U.S. interest rates raise a new challenge. Since 2009, Brazil’s economy got a boost from the U.S. Federal Reserve’s policy of extended historic low interest rates and quantitative easing (QE). Low interest rates gave Brazilian borrowers a chance to borrow from U.S. markets at low prices. Equally important, international investors starved for higher returning investments found Brazilian sovereign and corporate debt appealing, especially since the country gained investment-grade ratings during this period.

As long as interest rates remained low and the dollar stayed weak, borrowing in U.S. dollars worked very much in Brazil’s favor. The problem is that the U.S. currency has strengthened considerably in 2015 and the real has fallen in value. For an increasing number of Brazilian companies facing a contracting economy at home and the shrinkage of demand from its largest market, China, it will be more challenging to repay dollar-denominated debt. According to Fitch, Brazilian companies now have over $60 billion in overseas bonds outstanding and every 10-percent depreciation in the real boosts the companies' debt-to-earnings ratio "by a factor of one."

While Brazil’s federal government has done much to keep its debt under control (total external debt to GDP was 25.7 percent at year-end 2014, according to the International Monetary Fund), the same cannot be said for a number of the country’s state governments. According to the central bank, the Banco do Brasil, state and municipality debt rose to close to 12 percent of Brazil’s GDP at the end of May. This was the highest in more than five years.

The state issue has been given more significance by the August default of the southernmost state of Rio Grande do Sud on a 280 million real ($80.9 million) payment to the federal government. This is the first state government default since Brazil’s municipal-debt crisis in 1997. In Rio Grande do Sul, expenses are a problem. As Bloomberg’s Filipe Pacheco noted (August 21, 2015): “The state has already spent 26.8 million reais this year, more than any full year between 2004 and 2009. About a quarter of the outlays went to pay retired public employees.”

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