The timing of any decision to upgrade Brazil sovereign credits to investment grade was bound to be surprising whenever it occurred. Even for those who follow Brazil carefully, the improvement in Brazil’s financial indicators boggles the mind. How could a country with a long history of shaky finances that just yesterday seemed on the verge of default have made such a quantum leap?As recently as 2002 investors, both Brazilian and foreign, were dumping Brazilian debt massively amid fears of what the newly elected Lula government would do to destroy markets and upset debt contracts. That same government today is the darling of Wall Street. And how ironic, by the way, that the best trade to put on in 2002 would have been long Brazil and short the international banks that then worried so much about Brazil’s creditworthiness.
So having made clear that I applaud the upgrade action, I also wanted to raise some concerns in my mind about its timing and point to credit issues that remain valid about Brazil.
First, the upgrade clearly comes just as the favorable trends which have lifted the Brazilian economy appear to be receding. Brazil’s financial ratios (e.g., debt service burden, currency composition and maturity structure of the debt) have improved, true, but is not a large part of that improvement due to cyclical factors – commodity prices, capital inflows, strong growth in global demand for Brazilian exports? How good will some of these same indicators look if, as I suspect will be the case, the Brazilian current account widens rapidly in 2008 or international investors become less willing to invest in long-term local currency debt of the Brazilian government?
Second, and related, a closer look at indicators of creditworthiness do raise some questions in my mind. For example, the overall public debt to GDP ratio in Brazil is still well in excess of 40% of GDP, well above the 20% median for other BBB international sovereigns. Behind the scenes, Brazil has been spending at an accelerated pace in recent years, running nominal government deficits, and substituting (very expensive) local currency debt for foreign-denominated debt. The overall debt burden in Brazil remains high and so, too, does the tax burden. (See chart below.) At the same time, savings and investment ratios for Brazil are well below levels for investment grade peers.
Third, the international reserve level for Brazil is often cited as very positive credit factor. Indeed, reserves have skyrocketed to $195 billion, certainly providing a deep payments cushion. However, if the reserve levels are scaled in terms of the import coverage they represent (see graph below), it is clear that reserve coverage is highly cyclical in Brazil and that the overall import coverage ratio, while still high, may be declining as imports grow rapidly and capital inflows slow.
Fourth, it would seem obvious that a permanent improvement in creditworthiness has to depend upon policy innovations in addition to cyclical factors. In fact, for many years credit analysts have argued that Brazil needed to engage in a series of in-depth reforms, including social security and tax reforms, in order to underpin a sustained improvement in its finances. Yet after six years of the Lula government, I cannot think of a single major reform that has actually been passed and implemented. More than that, now that the upgrade has occurred, do politicians in Brasilia have an incentive to enact serious tax reform, for example, or to make tough decisions on curtailing spending as the economy cycles toward slower growth?
Fifth, it is a puzzle to explain why an investment grade sovereign credit raises debt domestically at the some of the highest real rates of interest in the world. Granted many factors influence the level of the real interest rates in Brazil, but default risk is certainly one of them. In fact, the Brazilian Central Bank has recently raised short-term interest rates to 11.75% which would imply a real cost of funds for the sovereign of at least 7%. Perhaps the rating agency action will coax some reduction in real rates. However, that reduction could be short-lived as, as I suspect, the real interest rate level reflect investor concerns about the long-term soundness of the public accounts.
While these concerns should give long-term investors have some pause for concern, one can still can feel that the upgrade caps off a remarkable period for President Lula. Wall Street is giving him a big abraço at the same time that his popularity levels at home after six years in office are at record levels. That is an investment-grade political feat.