Brazil enters the club of investment-grade economies. The only possible danger for Brazil could be the absence of reforms.
The group of elite global economies acquired a new member in April when Brazil moved a notch higher on Standard & Poor’s ratings ladder. Its sovereign debt is now ranked 14th in the world and is considered “investment class.” That means the Brazilian economy has attained international respect and recognition that it is a solvent country that can repay its debts. Brazil emerges from the group of countries – including Peru and Colombia, among others -- that are graded ‘speculative.’ It joins the BBB- group, which has investment grade status and includes such members as India and Romania. Nevertheless, Brazil still has a lot of room for improvement if it is to achieve AAA status along with such countries as Germany, France, Australia and the U.S.
WAITING FOR MOODY'S
Other ratings agencies are also raising Brazil’s status, including Fitch, which promoted the country to investment grade on May 29. Fitch’s ratings are based on political and economic data such as the volume of international reserves, economic strength and political stability, as well as such social factors as freedom of the press and income distribution. However, the criteria used by these agencies are not identical. Moody’s, another important ratings agency, still does not recommend Brazil to investors. However, in its latest report, Moody’s did place Brazil at the highest level of those countries that have speculative grade status. That leaves Brazil one step away from being recognized as a country that does a good job of repaying its debts.
According to Moody’s report, its classification of Brazil reflects “significant reductions in the country’s external vulnerability and reductions in the credit risk of the country as well as in the fiscal area.” In order to improve its rating further, Brazil will have to strengthen its indicators for government financing and deficits, says Mauro Leos, vice-president of Moody’s. When it comes to comparing the goals of the government for its primary surplus (the difference between government revenues and spending before payment of debt interest) with indicators for its public-sector debt, the agency believes that there have been only modest declines in recent years. Moody’s has some reservations about the high level of Brazil’s public-sector debt and structural impediments to adjusting the country’s budget, such as healthcare expenditures.
Even the S&P report, which praises “the track record of the administration’s pragmatic management of the debt,” notes that the government’s liquid debt is higher than that of many countries in the BBB category. Brazilian economists also point out the indicators that will have to be addressed carefully as the economy continues to grow. For example, Arminio Fraga, former president of Brazil’s Central Bank, recommends paying attention to the continuous expansion of public spending during the last decade, as well as to the significant shortcomings in such areas as education and infrastructure.
Nuno de Almeida, a professor at the Ibmec business school in Sao Paulo, also considers Brazil’s promotion to investment-grade status an important step for its economy. “The Brazilian government continues to have a very high level of spending in proportion to its GDP (Gross Domestic Product), and it is still growing in real terms,” says Almeida, who supports tax reforms. According to data from IGBE, the National Institute of Geography and Statistics, government spending grew by 19.25% during the first quarter of 2008 compared with the same three months in 2007.
Experts say it took a long time for Brazil to achieve this status, and it was not the result of random factors. Moreover, the achievement will have a wide-reaching impact. Fraga notes, however, that this won’t lead to any major changes in the short term because those changes have already been made during long years of discipline “and with good macroeconomic sense.” Experts are cautious about the 6.3% rally in the Sao Paulo stock market that followed the news about Brazil’s upgrade] when indicators reached an all-time high. In the days that followed, trading volume returned to normal.
Wagner Dantas, who heads the Wdantas Economic Consultancy in Sao Paulo, said these recent events make it clear that “much of the euphoria that followed the achievement of investment grade had already been discounted by the market.” For Dantas, the Brazilian market was too expensive, but he forecasts further price rises. “During the second half [of 2008], we will have a lot of turbulence in the market, but long term I continue to be optimistic about Brazilian stocks,” he states. One factor is the upcoming Brazilian municipal elections, which will begin to define the rules of the electoral game for the presidential campaign in 2010. Another is the bad news that has arrived from abroad as a result of the real estate crisis in the U.S.
De Almeida has a similar view. There is more demand for Brazilian stocks now that there is a possibility that institutional investors in foreign countries will bring more money into the country. “There will be even greater development in our financial sector in various areas,” he forecasts. The reasons for optimism, he adds, are simple: The less fearful people are about the possibility that they will not be repaid, the lower the cost of raising capital. In other words, it is cheaper to raise money for longer-term investments. Brazil is also attracting attention from the big investment funds whose statutes prohibit them from investing in countries that are considered too risky.
Manufacturers expect that achieving investment-grade status will improve the credibility of Brazilian corporations, so the cost of issuing Brazilian corporate bonds in foreign markets will tend to drop. Dantas foresees new horizons opening up for Brazilian companies, who will begin to discover new markets and benefit from the added visibility that comes along with investment-grade status. “With cheaper money, new products will be developed. We are going to see new mergers and acquisitions between Brazilian and foreign companies.”
Shorter term, Petrobras, the Brazilian oil company, says that it anticipates an increased volume of new investments in Brazilian government bonds. Indirectly, this will also provide more room for companies to be better evaluated by ratings agencies. Petrobras itself has had investment grade status since 2006 but it believes that the recognition of Brazil’s economy as a whole will translate into greater stability and predictability for investors, and will make it easy for the government to obtain financing.
De Almeida notes that “[Investment grade status] will bring cheaper financing for Brazilian companies and a higher rate of investment for the economy.” The impact will be felt in every indicator of growth. “We could grow at a higher rate than we have in recent years without generating inflationary pressure.” Some people even believe that, on the contrary, the growing influx of investments could lead to an upward revaluation of the currency. That would help control inflation, which reached 5.58% during the 12 months ending in May 2008. That figure was higher than the goal projected by the Brazilian Central Bank. Inflationary pressures have tormented the Brazilian government during the first half of this year, leading economists to raise their forecasts for inflation this year to six percent. However, those pressures are not sufficient to undermine the benefits that investment grade status will provide for the country’s economy, according to these economists.
“What we have achieved is historic, and we are still going to harvest the fruits mainly in the real, productive sector,” emphasizes Dantas. In his view, this will happen because the overall impact of achieving investment grade is structural. For Paulo Gala, a professor at the Getulio Vargas Foundation, “the economy continues to suffer short-term instability, however in a way that is less intense.”
The construction industry, currently bubbling with activity, is also optimistic. Gafisa S.A., one of the largest residential real estate developers in the country, believes that raising Brazil’s sovereign debt rating will encourage foreign companies to contribute financially to Brazil. “The economy will be positively affected by the increase in liquidity in debt and capital markets now that more investors will be able to play a part in Brazil’s strong growth,” notes Wilson Amaral, chief executive officer of Gafisa.
The influx of capital will also have an impact on Brazilian exports. “To the degree that Brazil’s new rating attracts additional foreign capital, that eventually raises the value of its currency, which has a damaging effect on exporters and on the country’s industrial sector,” warns Gala. He is referring to the strengthening of the real, the Brazilian currency.
Despite its improved status on the international credit scene, Brazil remains at the lowest rung of investment grade status. For credit agencies, that means Brazil is still vulnerable to adverse economic conditions, such as a more severe recession in the U.S. These kinds of evaluations are revised periodically, and there have been cases of companies whose high rating was later lowered, as in the case of Uruguay in 2002. The reason for a country’s eventual return to speculative grade might be a decline in the quality of the credit or increased vulnerability, for example. Other factors considered by the ratings agencies are forecasts of financial conditions and the impact of social conditions on the local economy.
So while Brazil’s macroeconomic fundamentals are strong, that should not lead to a further upgrade in Brazil’s status in the short term. As Dantas notes, “There are enormous obstacles that still must be overcome, such as the high ratio of debt to GDP; the bureaucracy; taxation levels and so forth.” Gala believes that continuous progress will depend on improving public accounts, and on managing the external sector. “If our external situation continues to worsen, we can have problems in the future,” he says.
For all that, if Brazil doesn’t neglect its basic needs -- its primary surplus and the way it manages inflation – and manages its external accounts, economists believe that the time has come for people to stand up and celebrate. “The Central Bank has acted with a great deal of discipline when conducting monetary policy, and that has been the most important thing at this time,” states Dantas, adding that the current level of reserves provides strong assurances when it comes to dealing with a future crisis -- a major source of oncern.
ABSENCE OF REFORMS
The experts don’t think it is possible for Brazil to lose its investment-grade status, not even because of the danger of inflation or because of a decline in interest rates. De Almeida suggests that Brazil’s high-powered battle against inflation will be viewed positively by ratings agencies. “When it comes to monetary policy, Brazil has been taking care of business,” De Almeida says. Adds Gala, “These days, inflation is a global phenomenon that affects every country.” Even investment grade countries are battling inflationary pressures by raising their interest rates. The only possible danger for Brazil could be the absence of reforms.
Economists generally agrees that any possible new upgrade in its rating cannot have as much impact as the recent upgrade. “Achieving investment grade status is what brings the greatest benefits for any country,” states De Almeida. Gala agrees, noting that this first transformation tends to have a stronger impact than later upgrades. Moving further up the ladder later on, he adds, provides only marginal benefits.
Republished with permission from http://www.knowledge.wharton.upenn.edu -- the online research and business analysis journal of the Wharton School of the University of Pennsylvania.