The numerous and complex economic challenges facing policymakers in the Federative Republic of Brazil (BB-/Stable/B) are debated frequently and very publicly, given the nation's vibrant democracy. Current topics of discussion have included the adequacy of Brazil's fiscal-monetary policy mix, the appropriateness of international reserve accumulation, and the government's relationship with the International Monetary Fund (IMF). All of these topics are pertinent to Standard & Poor's Ratings Services' assessment of Brazil's creditworthiness. However, their impact on Brazil's ability and willingness to repay its debt on time and in full depends on the level of the rating and on the forward-looking assumptions underpinning that rating.
Standard & Poor's raised its long-term foreign currency credit rating on Brazil to 'BB-' from 'B+' in September 2004. This rating is in the speculative-grade category, which, by definition, implies high credit risk and, consequently, room for improvement in Brazil's policy and economic fundamentals. Also, as a speculative-grade credit, Brazil's economic fundamentals are more vulnerable to changes in the global economic environment, and the adequacy of the government's policy response is less certain than that of investment-grade credits. These points must be kept in mind when putting in context the current topic under discussion. In addition, Brazil's fiscal vulnerabilities imply that fiscal policy has no choice but to remain prudent to maintain the current 'BB-' rating.
Brazil's Fiscal/Monetary Policy Mix
Given strong real GDP growth of 5.2% of GDP in 2004 and a high primary (noninterest) surplus, Brazil's net general government debt declined by eight percentage points to 53% of GDP in 2004. However, in 2005, Standard & Poor's expects the decline to be much more modest at only one percentage point; net debt is projected to decline to 52% of GDP. This smaller pace of improvement reflects an expected slower pace of real GDP growth of 3.9%, a smaller primary surplus, and somewhat higher real interest rates given the cycle of monetary tightening.
Given the stronger-than-expected pace of growth in GDP and in tax revenues in 2004, the government raised the nonfinancial public-sector primary surplus target to 4.5% of GDP in September 2004 and closed the year with an out-turn of 4.6% of GDP. The primary target for 2005, initially set at 4.25% of GDP, implied an easing in fiscal policy. The announcement in February 2005 that Brazil will take part in a three-year public investment pilot program with the IMF implies some additional easing of the 2005 primary target to about 4.1% of GDP. (This possibility was included in the 2005 budget sent to and approved by Congress.)
Are there rating implications for these decisions on fiscal policy at this time? Given current global economic conditions and other factors supporting the 'BB-' rating on Brazil—namely its strong external performance—the answer is no. However, it is important to underscore that within this context, Standard & Poor's expects that fiscal policy will continue to be prudently managed by the government, with revenue performance driving decision-making on expenditure execution. As a result, Standard & Poor's expects the 2005 primary fiscal out-turn to somewhat exceed the 4.1% of GDP target.
Criticism of government policy has focused on several key areas:
* More expansionary fiscal policy has contributed to the need for more restrictive monetary policy, given that actual and expected inflation remain above the 2005 consumer price inflation target of 5.1% of GDP.
* A healthier, more balanced policy mix would consist of a higher target for the primary surplus that could—all other things being equal—permit somewhat easier monetary policy.
* The increase in current government spending in 2004 contributes to the poor quality of Brazil's fiscal accounts.
* More needs to be done to reduce the high level of current public expenditure, which has been supported by a rising and complex tax burden that poses a disincentive for much-needed private investment.
Standard & Poor's concurs with such analysis. However, given other mitigating factors—such as solid external trade performance and the benign global financial conditions—there are not negative rating implications for this less-than-ideal current policy-mix at the 'BB-' rating level.
Nevertheless, the policy mix and composition of spending do limit the momentum for improvements in Brazil's creditworthiness, again, all else being equal. At a projected 52% of GDP for 2005, Brazil's net general government debt is higher than the 40% median for other countries in the 'BB' category. Absent stressed global economic conditions, which could demand a corrective adjustment in the current policy stance, running a higher primary surplus that supported lower real interest rates would likely reduce Brazil's debt-to-GDP ratio at a faster pace than Standard & Poor's currently expects. This, in turn, could support an improvement in creditworthiness. Although running a primary surplus near the current target is adequate for Brazil's debt burden, there is little to no room to lower the primary surplus further. Other countries with similar debt burdens have and do run larger primary surpluses, which have lowered their debt burdens at a faster pace than in Brazil.
For any given fiscal effort, greater expenditure flexibility, namely a lower share of nondiscretionary spending, enhances policy room to maneuver in the face of unforeseen shocks and tends to strengthen perceptions of creditworthiness. For a given fiscal effort, a greater share of spending on productive investment—such as in human or physical capital, which strengthens medium-term growth prospects—could also tend to support improved creditworthiness. Brazil's fiscal position could improve through a combination of these policies, which, in fact, has been highlighted by Standard & Poor's over the years.
The poor quality of Brazil's expenditure mix is not new. Nondiscretionary spending has accounted for 85% of total central government spending over the past three years. Central government payroll plus private-sector social security expenses (INSS) has risen by 15% in nominal terms in each of the last three years. Rationalization of payroll, additional efforts to reduce the public- and private-sector social security deficits, or both would tend to support improved creditworthiness.
The 2003 reform of the public-sector social security regime contributed to Standard & Poor's improved assessment of Brazil's creditworthiness despite the near-term fiscal savings being small because of its longer-term effects. However, the deficit for the public-sector regime remains high and constrains policy room for maneuvering. Furthermore, the INSS deficit has increased since the reform of 1999. At 1.8% of GDP in 2004, the INSS deficit is almost double the then-projected stabilization of the deficit at 1% of GDP associated with that 1999 reform, which better aligned benefits and contributions. However, continued deterioration has been mostly because of the link between INSS benefits and increases in the minimum wage, highlighting the need for additional reform.
Brazil's tax burden is very high for its level of economic development and poses a disincentive for private investment. Raising taxes has been key to raising the primary surplus to current levels of more than 4% of GDP from 0% of GDP in 1998. Unfortunately, Standard & Poor's sees little scope for Brazil to reduce the tax burden given the need to maintain a high primary surplus until the level of current, nondiscretionary expenditure and the magnitude of the debt burden are reduced. This will take time and concerted political effort. In the meantime, continued efforts to simplify the system could somewhat mitigate the problematic overall level of taxation.
With an even stronger fiscal performance than that currently targeted by the government, the financial markets' perceptions of risk could support a faster reduction in overnight interest rates by Banco Central and a decline in real interest rates. One can debate whether the exact level of Brazil's inflation targets should or could be slightly higher given the disagreement about Brazil's institutional constraints and the speed at which inflation can credibly be reduced. However, it is very clear that to enhance medium-term growth prospects, there is nothing to be gained by having high inflation. Brazil's inflation is still high by international standards. Given its too-recent history of very high inflation, changing the mentality of investors and consumers to expect and believe that inflation will converge to international levels takes time. In this regard, Banco Central's commitment to and success in lowering inflation is crucial. Standard & Poor's believes that monetary policy credibility could be further enhanced with formal central bank independence supplementing its operational independence.
Another fiscal challenge is improving the composition of Brazil's domestic debt. The government succeeded in improving the debt composition, which was reflected in Standard & Poor's upgrade of Brazil in September 2004. The country's share of dollar-linked paper stood at 8% of domestic debt at the end of January 2005 from 22.1% in December 2003 and 37% in December 2002. This, in turn, helps insulate the debt burden and fiscal balances from fluctuations in the exchange rate.
However, the share of paper linked to overnight interest rates is high at more than 50% of domestic debt, leaving fiscal balances and debt-to-GDP vulnerable to fluctuations in short-term interest rates. In addition, the maturity structure of Brazil's domestic debt is only 21 months for securities issued via a competitive tender. Although the government successfully raised the share of fixed-rate paper to 18.7% of domestic debt in January 2004 from 12.5% in December 2003 and 2.2% in December 2002, it has done so at the cost of a slight reduction in average tenor. This highlights the difficult tradeoffs involved in domestic debt management, especially when starting with a poor debt structure. Tax breaks on holdings of longer-term paper announced in mid-2004 could facilitate some lengthening of tenors, but that also depends on the ongoing establishment of a sound policy track record, a reduction in the government debt burden, low inflation, and institutional efforts to improve liquidity in the secondary market.
External Vulnerability
Brazil's external debt burden, though much improved, is still high. External debt net of liquid assets is projected at about 120% of exports of goods and services for 2005-2006, down significantly from 300% in 2000. However, the ratio averages a much lower 50% on average for other 'BB' credits. Brazil depends on the capital markets to meet its external financing needs, which is another source of vulnerability given the volatility in investor sentiment. Brazil's vulnerability (as measured by its external financing needs), however, has also improved in recent years. Gross financing needs—defined as the current account deficit, medium- and long-term amortizations, and short-term debt—are projected at 100% of gross international reserves in 2005-2006, down from 300% in 2000.
The significant improvement is in part because of Brazil's strong trade performance. With merchandise exports having grown by 32% in 2004 and still outpacing the pick-up in imports, the trade surplus peaked at $33.7 billion and continues to post records in 2005. Although Brazil's export base has doubled over the past five years to about 19% of GDP, it is low compared with other countries Standard & Poor's rates in the 'BB' category, the exports of which average 30% of GDP.
However, the improvement in financing needs also reflects the higher level of international reserves compared with 1999-2002. The government's policy of accumulating international reserves since December 2004 as market conditions permit, like in early 2004, has led to the accumulation of about $10 billion in international reserves as of March 2005 since December 2004. In light of Brazil's amortization profile that includes net repayments to the IMF in the coming years, these international reserves serve as a precautionary buffer and lower financing risks for Brazil. Although the strategy of building international reserves does entail fiscal costs and complicates the conduct of monetary policy, the combination of Brazil's fiscal and external vulnerabilities implies that many policy decisions in Brazil entail balancing tradeoffs.
Given the time needed to bolster Brazil's export base further and lower its external debt burden, prudent accumulation of international reserves is a way in which Brazil can mitigate some of its financing vulnerabilities. Brazil's gross financing needs, at 100% of international reserves, compares with 90% for other 'BB' credits. Although much improved, Brazil's debt-servicing ratios remain higher than those of peer credits. Debt service (even excluding short-term debt) as a share of exports of goods and services will still be about 40% in 2005-2006 (down from 97% in 2000), which is still much weaker than about 15% for the 'BB' median.
The IMF
Whether or not to extend the current stand-by arrangement with the IMF, which expires at the end of March 2005, is a decision for Brazil's government. Standard & Poor's policy is not to advise whether or not any government should undertake a program. That said, creditworthiness can be affected by the presence or absence of an IMF program in certain instances.
Under current global economic and liquidity conditions, the current 'BB-' rating on Brazil is not dependent on whether or not the government extends the program because Standard & Poor's assumption is that Brazil is committed to a prudent macroeconomic policy mix with or without a formal IMF stand-by program. Standard & Poor's does not believe that Brazil needs a formal IMF program to foster or further strengthen a culture of fiscal responsibility, as is the case in some lower-rated sovereigns. In addition, Standard & Poor's expects Brazil to continue to engage the IMF on discussion of policy—like with the three-year public investment pilot program—with or without a formal program.
The announcement that Brazil will participate in this IMF pilot program was expected. The program entails a modest easing of fiscal policy targets for investment in carefully selected infrastructure projects. It does not imply off-budget accounting but rather continued transparent fiscal accounting. Calculations of the results for the overall fiscal balances and primary balances will include these expenditure outlays. All potential expenditures are expected to continue to be outlined in the budget process.
Similar types of expenditures had already been negotiated with the IMF and incorporated in Brazil's fiscal accounts and budgeted from 2003 to 2005. This has included some spending by Petrobras and by municipal governments on various sanitation projects in 2003 and 2004. Such spending has been prudently managed, has not been excessive, and has not compromised Brazil's overall primary surplus commitment. Standard & Poor's expects that, similar to investment decisions under the Public Private-Sector Partnerships framework, the government will be selective in focusing on sound, well-run, and beneficial investment projects under the pilot program. In fact, all other things being equal, more productive investment spending and less current spending for a given primary fiscal effort would improve the quality of Brazil's fiscal balances.
Brazil has not drawn funds from its IMF program since September 2003. With current global liquidity conditions and current underlying economic fundamentals in Brazil, the government is not dependent on the IMF for financing. This contrasts sharply with the environment of 2002 when questions about the prospective policy stance under a government led by the Partido dos Trabhaladores and deteriorating debt dynamics contributed to lack of affordable market financing. In that circumstance, the IMF played a key role providing financing.
Some sovereigns with higher ratings than Brazil do negotiate IMF programs for contingency purposes. Sovereigns rated in the investment-grade category generally do not have IMF programs. However, that does not imply that a prerequisite for being assigned an investment-grade rating is not having an IMF program. Rather, it is that the combination of underlying the strength in economic fundamentals and predictability of policy is such that investment-grade credits do not need to have an IMF program. Given the strong track record of Brazil's meeting IMF targets and its working relationship with the IMF, under a scenario of stressed global economic conditions and extremely unfavorable terms for market financing, Standard & Poor's expects that Brazil would readily renegotiate a program with the IMF and gain access to funding.
The Potential For An Upgrade Depends On Brazil's Policies
To conclude, the current policy stance and composition of Brazil's expenditure and tax burden do not have negative implications for the current 'BB-' rating on Brazil given the other factors underpinning the rating. At the same time, however, it does limit the upside potential for the rating. A fiscal stance that led to a faster reduction in debt to GDP, reform that permitted more fiscal flexibility and improved the quality of public spending, and a less-vulnerable domestic debt structure would support stronger creditworthiness. Standard & Poor's believes that Brazil's political leaders and the economic team understand these constraints. As policymakers, however, they balance the goal of higher creditworthiness with other political objectives. Given the time needed to bolster Brazil's export base further and reduce its external debt burden, prudent accumulation of international reserves is a way in which Brazil can mitigate its financing vulnerabilities. From a medium-term fundamental perspective, however, continued growth in exports is a more compelling driver for improved creditworthiness. The decision on whether or not to renew a formal program with the IMF again balances political objectives. At this time, there are no implications for the rating if the government does not decide to renew the program, given the benign global financial conditions, the expectation of an ongoing prudent policy stance by the Brazilian government, and improvement in fiscal and external vulnerabilities during the past several years.