Making the grade

Brazil gets recognition for improved economic management

Investment-grade status, which was awarded to Brazil’s foreign-currency-denominated debt on April 30th by Standard & Poor’s, one of the main US credit rating agencies, is an acknowledgment of the important progress achieved in macroeconomic management and of a substantial improvement in external solvency ratios. Indeed, with reserves close to US$200bn, Brazil has become a net external creditor. Nevertheless, weaknesses persist, as the government has confirmed its intention to keep increasing public spending as part of its state-led development policies.

The quest for investment grade was so long and fraught with difficulties that financial markets were taken somewhat by surprise when Standard & Poor’s (S&P) raised Brazil’s long-term foreign-currency credit rating from BB+ to BBB- on the eve of the May 1st Labour Day holiday. Even though some investors thought the upgrade had been long overdue, few expected it to materialise before the end of the year due to current global uncertainty. The Latin American giant is now on par with India, according to S&P’s ratings, but still two notches below the ratings given to Russia and Mexico, and far below that of China.

The Economist Intelligence Unit, for its part, has held its BB rating for Brazil under its country risk model. This remains just short of investment grade, and reflects a weakening current account and risks to key macroeconomic indicators, given the impact of a US recession. However, steady GDP growth and a falling debt interest burden will still underpin a score at the strong end of the BB band, and an upgrade to EIU’s sovereign rating is quite possible in the medium term.

Fitch Ratings, another credit rating agency (which upgraded Peru to investment grade in March), has said Brazil’s sovereign rating was under “active review”, while Moody’s has pointed out that Brazil’s indicators are not yet as good as other investment grade countries.

Vote of confidence

The Standard & Poor’s upgrade is a strong vote of confidence and a milestone in Brazil’s economic history, after years of mistrust following the 1987 debt default. The macroeconomic management of the government of Luiz Inácio Lula da Silva has been widely praised, although improvements have been partially a consequence of the extremely positive external environment until last year. The US subprime crisis and the accompanying global financial turbulence have put the resilience of Brazil’s economy to the test. Even though it may eventually suffer some fallout should global conditions worsen, S&P says that Brazil has already passed such a test.

There is ample evidence that Brazil’s external vulnerability has been significantly reduced. Instead of slashing interest rates aggressively during years of financial bonanza and low inflation, the Central Bank maintained a cautious and gradual monetary policy and piled up large amounts of foreign reserves. In February, the announcement that Brazil had become a net international creditor was a further sign of improvement in its solvency ratios.

In addition, the amount of public debt declined to 41.2% of GDP as of March. While the overall stock of debt is still relatively high, S&P has praised “a fairly predictable track record of pragmatic fiscal and debt management policies”. One of the most positive impacts of the upgrade itself may be to reduce the cost associated with financing the sovereign debt and to improve its profile.

Responsible Central Bank

Brazil’s economic activity is currently sustained by vigorous domestic demand, which helped boost GDP growth to 5.4% last year from 3.7% in 2006. Record levels of tax collection have helped the government to easily meet its primary budget targets (even though public spending is still high). During the first quarter of 2008, Brazil even registered a nominal budget surplus.

On the inflation front, the Central Bank faces challenges as supply-side factors and excess demand exert inflationary pressures. The benchmark IPCA index posted a 4.7% increase over the 12-month period leading to the end of March, which is slightly above the central inflation target (4.5%, although there is a two-point tolerance margin). Apart from food price inflation, there will be additional pressures as oil refinery prices increase by 10% on May 2nd (some of the impact will be offset by a cut in a fuel tax, known as Cide).

Nevertheless, in spite of well-known divergences between the government and the Central Bank over monetary policy, the Central Bank has displayed repeated evidence of its operational autonomy, tightening monetary policy in April by 50 basis points for the first time in almost three years. This pre-emptive tightening—in what appears to be the start of a mini-tightening cycle—was in itself an important indicator of its institutional strength. Although there are policy rifts and power struggles within the Lula administration, and the policy framework is by no means perfect, it is pragmatic and predictable.

Meanwhile, the positive impact on investment flows will certainly lead to a further appreciation of the Real on the foreign-exchange markets. This may help keep inflation down, although the current-account deficit (which already amounted to 0.7% in March over 12 months) is expected to widen. Nevertheless, the Central Bank expects even stronger flows of foreign direct investment, which will help cover this deficit.

Investors cheer

The investment grade rating by S&P, which will probably be matched by upgrades from Moody’s and Fitch in due course, will lower the cost of capital in Brazil and thereby boost the country’s growth prospects. The stock market has already reflected the new wave of optimism. Even though the upgrade was made public less than two hours before local markets closed, the Bovespa rallied on April 30th (it was closed on May 1st), converting the Bovespa’s 2008 loss into a gain of 6.2%—and making it the best performer among the 20 world’s largest bourses this year.

In addition to the sovereign move, S&P also upgraded the ratings of the electricity holding Eletrobras and eight Brazil-based banks. Itaú and Bradesco were already investment grade and gained one notch, while the others obtained investment grade. These were state-owned Banco do Brasil, Banco Nacional de Desenvolvimento e Social (BNDES), Banco do Nordeste do Brasil (BNB), as well as Unibanco and the local subsidiaries of Banco Santander (Spain) and HSBC (UK).