Fitch Affirms Brazil at 'BB'; Outlook Negative

NEW YORK--()--Fitch Ratings has affirmed Brazil's Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) at 'BB'/ Negative Outlook. Brazil's senior unsecured Foreign- and Local-Currency bonds are also affirmed at 'BB'. The Country Ceiling is affirmed at 'BB+' and the Short-Term Foreign and Local-Currency IDRs at 'B'.

KEY RATING DRIVERS

Brazil's 'BB' rating is supported by its economic diversity and relatively high per capita income. The country's capacity to absorb shocks is bolstered by its flexible exchange rate, robust international reserve holdings, strong net sovereign external creditor position, and deep and developed domestic government securities markets. The small share of foreign currency debt in total general government debt limits vulnerability of debt dynamics to FX movements. These strengths are counterbalanced by the structural weaknesses in public finances, high government debt burden and weak growth prospects. Some of these challenges have been exacerbated by the fallout from wide-scale corruption investigations in the recent past.

The Negative Outlook reflects Brazil's continued large fiscal imbalances and adverse government debt dynamics along with uncertainty as to the implementation of fiscal measures that improve prospects for debt stabilization. Despite the recent lessening of political uncertainty, setbacks in the executive's fiscal agenda in congress cannot be ruled out, which in turn could hit confidence and increase downside risks to our baseline economic and fiscal scenarios.

Fiscal challenges persist in Brazil with the government adopting a gradual fiscal consolidation process, targeting a public sector primary deficit of around 2% of GDP in 2017 and returning to a surplus only in 2019. Fitch's projections of primary balances are in line with the authorities' and we project general government deficits to average around 8% of GDP in 2017-2018 (compared with the 'BB' median of around 3.5% of GDP). This will result in a continued rise in the general government debt burden during 2016-2018 and beyond unless economic growth rebounds more strongly and/or higher primary surpluses are achieved. Fitch currently projects the general government debt to rise from 66.5% of GDP in 2015 to around 80% of GDP in 2018 (compared with the expected 'BB' median of 52%). A slower economic recovery, greater challenges in subnational finances, and difficulty in passing or dilution of intended fiscal measures in congress could hamper the fiscal consolidation process and negatively affect debt dynamics.

The two key fiscal reforms that the government intends to pursue to reverse the increasing primary spending trend and facilitate medium-term fiscal consolidation are the spending cap and social security reform. The main tenet of the spending cap is to constitutionally limit the increase in total federal primary spending to the previous year's inflation rate, which would lead to a decline in the primary spending-to-GDP ratio with positive GDP growth, imparting greater fiscal discipline and improving the predictability of longer-term spending trends. Given the preponderance of social security spending and its expected growth, social security reform would be essential to make the spending cap effective and credible. The social security deficit has been rising in recent years and is expected to surpass 2% of GDP in 2016. The authorities intend to seek approval for social security reform in 2017 although the exact details of this initiative are unknown.

Brazil's economy is expected to contract for a second year in 2016. Fitch forecasts GDP growth to reach -3.3% in 2016 before recovering to a modest 1.2% in 2017 and 2.2% in 2018. Reduced political uncertainty, improvement in the overall policy environment, a recovery in Brazilian asset prices and revival in business and consumer confidence indicators would all support the recovery. The Temer administration is signalling a more market-friendly approach to economic policies, such as strengthening the framework for engaging the private sector in infrastructure investment and reducing broader state intervention.

Political uncertainty has fallen following the completion of the impeachment proceedings against ex-President Rousseff. Michel Temer has been confirmed as president following the impeachment vote and is expected to complete the remainder of the term until 2018. Governability should be supported by President Temer's sizeable coalition in both houses of congress although the stability and discipline of the coalition will be tested as the government pursues its legislative agenda. While the prospects for reform have improved, the extent of progress and dilution of these initiatives is still uncertain. The social security reform could prove to be more contentious. The president's low popularity, rising unemployment rate and lacklustre growth, and the ongoing Lava Jato proceedings are risks for the political environment and could challenge reform progress.

On the positive side, Brazil's macroeconomic imbalances are correcting course. The deep recession and BRL depreciation are leading to a material reduction in the current account deficit, which is forecasted to reach 1% of GDP in 2016, down from the recent peak of 4.3% in 2014. Fitch forecasts it to remain moderate, averaging around 1.5% of GDP during 2017-18 and should be fully financed by foreign direct investment flows. The central bank has also significantly reduced its net position of FX swaps in recent months, thereby reducing its exposure to future FX depreciation. Headline inflation has peaked and is on a declining path and inflation expectations have evolved favorably for 2017 and beyond, converging on the target of 4.5% for 2018.

SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns Brazil a score equivalent to a rating of 'BBB-' on the Long-Term FC IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:

--Public Finance: -1 notch, to reflect Brazil's rapidly worsened general government debt burden which is projected to continue rising during the forecast period. Moreover, fiscal flexibility is hampered by the highly rigid spending profile and a heavy tax burden that makes adjustment to shocks difficult.

-Structural Features: -1 notch, to reflect Brazil's challenging political environment and corruption-related issues that have made it difficult for the country to make timely policy adjustments. In addition, the Ease of Doing Business indicators are weaker than the 'BB' median, reflecting structural constraints to growth.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centered averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

RATING SENSITIVITIES

The main factors that could lead to a downgrade are:

--Failure to arrest the pace of increase in the government debt burden and/or crystallization of contingent liabilities.

--Policy drift and an inability to implement measures that improve the outlook for growth and public finances.

--Erosion of international reserves and deterioration in government debt composition.

The Rating Outlook is Negative. Consequently, Fitch's sensitivity analysis does not currently anticipate developments with a high likelihood of leading to a positive rating change. Future developments that could individually, or collectively, result in a stabilization of the Outlook include:

--Improvement in policy implementation and reform progress that supports confidence, investment and growth prospects.

--Fiscal consolidation that leads to greater confidence in the capacity of the government to achieve debt stabilization.

--Sustained improvement in macroeconomic imbalances and better investment and growth environment.

KEY ASSUMPTIONS

--Fitch assumes that China (an important trading partner for Brazil) will be able to manage a gradual slowdown and is forecasted to grow at 6.5% in 2016 and 6.3% in 2017, offering a limited upside for commodity prices. Argentina's economic performance (key destination of manufacturing exports) is projected to improve over the forecast period.

--Fitch assumes that Brazil maintains international and domestic market access even if there is return of higher international financial volatility and further domestic confidence shocks.

Additional information is available on www.fitchratings.com

Applicable Criteria

Country Ceilings (pub. 16 Aug 2016)

https://www.fitchratings.com/site/re/885997

Sovereign Rating Criteria (pub. 18 Jul 2016)

https://www.fitchratings.com/site/re/885219

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1014674

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1014674

Endorsement Policy

https://www.fitchratings.com/regulatory

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Contacts

Fitch Ratings
Primary Analyst
Shelly Shetty
Senior Director
+1-212-908-0324
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Todd Martinez
Associate Director
+1-212-908-0897
or
Committee Chairperson
James McCormack
Managing Director
+44 203 530 1286
or
Media Relations:
Elizabeth Fogerty, New York, +1 212-908-0526
Email: elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Shelly Shetty
Senior Director
+1-212-908-0324
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Todd Martinez
Associate Director
+1-212-908-0897
or
Committee Chairperson
James McCormack
Managing Director
+44 203 530 1286
or
Media Relations:
Elizabeth Fogerty, New York, +1 212-908-0526
Email: elizabeth.fogerty@fitchratings.com