Brazil’s credit outlook adjusted to stable by Moody’s Ratings

Investing.com -- Moody’s Ratings has today revised the credit outlook for the Government of Brazil from positive to stable. Alongside this, the long-term local and foreign currency issuer rating and senior unsecured bond ratings have been affirmed at Ba1. The senior unsecured shelf rating has also been confirmed at (P)Ba1.

The adjustment in outlook to stable is due to a decrease in upside credit risks, which is a result of a notable deterioration in debt affordability and slower progress in addressing spending rigidity and building credibility around fiscal policy. This is in spite of the government’s commitment to primary balance targets. The government’s capacity to significantly reduce fiscal vulnerabilities and stabilize debt burden in the short term remains limited by spending rigidity and increasing borrowing costs. These challenges counterbalance potential investment and GDP growth, as well as ongoing economic reforms that support Brazil’s credit quality. Moody’s now assesses the credit risks as balanced at Ba1.

The affirmation of Brazil’s Ba1 rating reflects the country’s robust growth of its large and diversified economy, a proven history of reform implementation over successive administrations, and limited vulnerability to external shocks due to a strong external position. These credit strengths are balanced against a high and rising debt burden, high interest payments, and a rigid spending structure that restricts the government’s ability to respond to shocks.

Brazil’s country ceilings remain unchanged. The local-currency country ceiling is four notches above the sovereign rating at A3, reflecting external stability and moderate political risk, balanced against the government’s relatively large footprint in the economy. The foreign-currency country ceiling is Baa1, one notch below the local-currency country ceiling, reflecting large foreign exchange reserves, reducing the risk of restrictions on transfer and convertibility in times of stress, and an open capital account, balanced against exchange-rate volatility and some restrictions on short-term capital flows.

Over the past three years, Brazil’s real GDP growth has remained strong at around 3%, and the government has met its primary deficit targets as expected. However, a significant increase in inflation and inflation expectations in the context of strong economic activity led the central bank to resume forceful monetary policy tightening. Due to the government debt structure’s sensitivity to interest rate movement, interest payments will increase materially leading to larger overall fiscal deficits and debt accumulation in 2025-26 than previously expected. Market concerns over the direction of fiscal policy have also contributed to the rise in inflation expectations and risk premium on government debt.

Because of reliance on variable-rate and inflation-linked debt, Brazil’s fiscal profile is highly susceptible to interest rate movements. Shortcomings in monetary policy channels of transmission result in large and rapid shifts in the interest rate environment, weakening the impact of fiscal consolidation efforts during tightening cycles.

Although the fiscal policy stance has not changed, Moody’s now expects Brazil’s debt burden to stabilize around 88% of GDP in the next 5 years, up from 82% in October 2024, mostly driven by larger-than-expected interest payments. They estimate that the interest-to-revenue ratio will peak in 2025 close to 21%, up from around 15% in 2023.

While the government is expected to achieve a primary balance, spending rigidity and rising interest payments limit the prospects of additional expenditure cuts to compensate for the impact of rising borrowing costs on the debt burden. Despite successive governments taking steps to improve fiscal management, revenue earmarking, a large share of mandatory spending, and susceptibility to interest rate movements constrain the scope for adjustments.

The current administration introduced revenue measures to meet primary deficit targets and a cap on increasing minimum wage, in line with the fiscal framework, which will contribute to reducing mandatory spending over time. However, deeper reforms, such as reducing revenue earmarking and de-linking social benefits from the minimum wage, would be needed to alleviate much of Brazil’s spending rigidity and increase the government’s ability to respond to shocks. Structural spending reforms would also help lower inflation expectations and interest rates more broadly.

Building consensus around the design and implementation of deeper spending reforms would involve the government, Congress, and the public more broadly, which will likely take time.

Furthermore, the government aims to rebalance its debt structure towards fixed-rate instruments and extend debt maturity in the coming years. The strategy involves increasing the share of fixed-rate and inflation-linked instruments, extending debt maturity, smoothing the maturity profile, and maintaining liquidity buffers to manage short-term shocks effectively. Such changes to the debt profile will likely be gradual. As such Moody’s are not expecting significant change in the short run.

The affirmation of the Ba1 ratings reflect Brazil’s large economic size and diversification, and limited vulnerability to external shocks given its domestic-driven economy and strong external position. Brazil’s economy has displayed more robust growth in recent years partly as a result of structural reforms implemented over successive administrations and a growing track record of economic and fiscal reforms that lend resilience to the credit profile.

The affirmation also reflects Moody’s view that ongoing fiscal consolidation efforts, although gradual, will stabilize debt burden in the medium term. However, limited progress on deeper structural reforms to address spending rigidity and the high sensitivity of fiscal outcomes to interest rate movements constrain upward rating momentum in the short term. Brazil has the potential to sustain higher GDP growth by attracting investment in renewable energy production and energy-intensive sectors and is relatively less impacted by global policy uncertainty, mitigating the risks related to elevated debt burden and borrowing costs.

Brazil’s Credit Impact Score (CIS-3) reflects exposure to environmental and social risks, and moderately strong institutions. Social and environmental risks are driven by high income inequality and exposure to carbon transition risk.

Brazil’s exposure to environmental risks (E-3 issuer profile score) reflects carbon-transition risk, impacting its oil sector, and risks related to waste and pollution, water management and the depletion of natural capital. However, those risks are mitigated by Brazil’s significant endowment of natural capital and its continental landmass, where any given climate shock impacts only part of the country.

Exposure to social risks (S-3 issuer profile score) reflects high income inequality and some deficiency in the provision of basic services, notwithstanding a large social safety net. Future social pressure may arise if employment and wage growth were to persistently weaken, leading to deterioration in living standards.

The influence of governance on Brazil’s credit profile (G-2 issuer profile score) reflects the effectiveness of economic, political, and judicial institutions in enacting difficult reforms across multiple administrations and strong monetary policy framework set against Moody’s assessment of the impact of relatively weak governance indicators related to corruption and rule of law.

Brazil’s sovereign rating could be upgraded if a broad consensus among policy makers and Congress emerges to advance deeper spending reforms. For example, measures that would reduce earmarking of revenues, indexation of social benefits to the minimum wage, or reform to social security benefits would create fiscal space and improve the credit profile. More broadly, macroeconomic reforms that improve the monetary policy framework, leading to a more effective transmission of monetary policy would also contribute to reducing the vulnerability of Brazil’s fiscal position to cycles of monetary policy tightening.

The rating could face downward pressure if fiscal consolidation efforts were reversed or less effective than currently assumed, further weakening investor confidence and resulting in persistently weaker debt affordability and debt metrics. Signs of materially weaker growth would also weigh on Brazil’s credit profile and could prompt a negative rating action.

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