As FSG has long anticipated, Brazil was downgraded yesterday by S&P less than two weeks after having submitted a 2016 budget with a primary fiscal deficit of -0.3 percent of GDP (well off its original primary surplus of 0.7 percent of GDP). The failure of the Rousseff administration to align on needed adjustments was cited by S&P as evidence of the government’s continued inability to consolidate the country’s fiscal position and was sufficient for the rating agency to revoke Brazil’s stamp of approval as a reliable payer.
Impacts to Brazil’s economy
At FSG we believe that S&P’s downgrade will have the following short-term impacts to Brazil’s economy:
- Potential pullback of institutional investments: Most pension funds have rules that restrict their investments to assets with investment grade ratings granted by at least two major credit rating agencies. If Moody’s or Fitch were to follow suit and downgraded their own ratings for Brazil’s sovereign debt to junk status, a significant number institutional investors would have to withdraw their funds from Brazil, triggering a new wave of capital outflows.
- Heightened currency volatility: The immediate consequences of this withdrawal will be to put further downward pressure on the BRL/USD exchange rate.
Markets reacted to the news and the expected withdraw of foreign capital by pushing the real/dollar exchange rate down more than 2 percent in early trading on Thursday morning. Notably, markets had already begun to price in an eventual downgrade following the release of the 2016 budget on September 1, with the real falling significantly over the past 10 days. Such movement would suggest that the immediate reaction in currency markets will be somewhat modulated, though expect continued volatility until there are clear signs that the political will exists to enact significant policy adjustment.
- Rising borrowing costs: Higher country risk will increase credit spreads for financial institutions looking to access international capital markets. Higher spreads on cross-border interbank lending transactions will ultimately translate into higher interest rates for the public and private sector in Brazil. This would effectively place even greater downward pressure on investment and consumption, both of which have weighed heavily on growth over the past year.
- Higher inflation: Further depreciation of the real will also generate more pressure on prices, potentially forcing the central bank to extend its monetary tightening cycle, and contributing to even higher interest rates. Notwithstanding monetary policy, the ability of the government to signal a stronger commitment to fiscal responsibility will be key to anchoring inflation expectations moving forward.
Brazil’s political outlook remains uncertain; indeed this was one of the main factors contributing to yesterday’s downgrade. Some political analysts have suggested that now that Brazil has lost its investment-grade rating, and given that a large cohort within Rousseff’s Workers Party never agreed with austerity measures to start with, the government could throw in the towel and reverse course. At FSG we believe that the government has little choice but to remain committed to fiscal responsibility. The PMDB, which controls both houses in congress, and the PSDB, the most important party in the opposition, were instrumental in stabilizing Brazil’s economy in the 90’s through orthodox macroeconomic policy, and a return to irresponsible fiscal policies would most likely face strong popular opposition as it would inevitably lead to much higher inflation rates.
The government has already signaled that it will send new measures to the legislative branch in the coming weeks in the hopes of meeting its 2016 primary surplus target of 0.7 percent of GDP. It is possible that the recent downgrade will put pressure on congress to begin voting on fiscal measures proposed by the Rousseff administration, allowing for a more robust adjustment.
Impacts to multinationals and actions to take
- Weaker domestic demand: Yesterday’s downgrade is certainly not good news for the short-term prospects of the Brazilian economy. Executives should expect the employment situation to deteriorate further while consumer and business confidence remain depressed until the political outlook becomes clearer. Multinationals should focus on protecting sales volumes in their market strongholds by being tactical around pricing and product positioning strategies and at the same time consider expanding into new segments or geographies within Brazil that are proving more resilient against economic recession. In order to help clients identify still-growing markets within Brazil, FSG recently published a new report about Subnational Prioritization in Brazil for B2B, B2C and Healthcare (client-only downloads).
- Falling market share for imported products: Additionally, the continued devaluation of the real will reduce margins for multinationals and their distributors. This will force many companies to increase final prices and risk losing market share vis-à-vis local platers. With expectations for further depreciation of the Brazilian real on the back of rising interest rates in the US, companies should go beyond financial hedging strategies and consider increasing their operational presence in Brazil; a weaker real and lower company valuations will present very attractive opportunities for companies to increase their local presence through strategic acquisitions. Read our reports about Local Manufacturing in Brazil and Brazil’s Second M&A Wave (client-only downloads) for management best practices on how to localize your business in Brazil.
- Reduced government spending: With federal, state and municipal governments facing higher borrowing costs and having to stay committed to fiscal consolidation, executives should expect further delays in tenders, continued cuts to public budgets and greater price sensitivity at all levels of government. For help understanding which public sector entities are most vulnerable, see our most recent Brazil Quarterly Market Review (client-only download).
- Higher borrowing costs for partners and customers: With business and consumers facing tighter access to credit, multinationals can protect current sales and deepen partner relationships by supporting their partners across the cash conversion cycle through extending payment terms or providing direct lending. Some companies have seen success helping their distributors shorten their own cash collection cycles by providing them with letters of recommendation for invoice factoring applications with commercial banks. If you want to learn more about how to support channel performance read Channel Strategy in Brazil (client-only download).
While yesterday’s downgrade could tarnish Brazil’s reputation in the eyes of international investors over the near-to-medium term, it could also prove to be a catalyst for action that breaks the congressional gridlock that has left Brazil in this mess. However, expectations should be tempered as the disagreements amongst the country’s political elites run deep, and President Rouseff’s popular support remains at an all-time low. That said, Brazil’s long-term fundamentals remain strong, and companies that stay committed to the Brazilian market while making the right investments today will position themselves to gain market share and reap the benefits of renewed growth over the long term.
Image: Credit: Ricardo Moraes/Reuters