Fitch Revises Brazil's Rating Outlook to Negative

Fitch Ratings has revised the Rating Outlook on Brazil's Long-term foreign and local currency Issuer Default Ratings (IDRs) to Negative from Stable and affirmed the IDRs at 'BBB'. The issue ratings on Brazil's senior unsecured foreign and local currency bonds are also affirmed at 'BBB'. The Country Ceiling is affirmed at 'BBB+' and the Short-term foreign currency IDR at 'F2'.

KEY RATING DRIVERS

The revision of the Outlook to Negative reflects the following key factors:

Brazil's continued economic underperformance, increased macroeconomic imbalances, deterioration of fiscal accounts and a material increase in government indebtedness are increasing downward pressure on the sovereign credit profile. While the government has begun a macroeconomic adjustment process to boost policy credibility and confidence, downside risks related to its effective implementation and durability persist, especially in the context of a challenging economic and political environment. Additional domestic and external shocks could undermine the pace and scope of the adjustment process.

The Brazilian economy grew by a mere 0.1% in 2014 and is forecast to contract by 1% in 2015. Brazil's three-year growth average of only 1.5%, compared to the 'BBB' median of 3.2%, highlights the structural nature of the under-performance. The macroeconomic adjustment process currently underway, if effectively implemented, could lead to a revival in confidence and growth in 2016 and beyond but growth will likely remain below that of rating peers. Medium-term growth prospects would largely depend on the government's ability to reverse the downshift in confidence and improve the competitiveness of the economy by making progress on microeconomic reforms.

Elevated inflation and the 'twin deficits' highlight Brazil's macroeconomic imbalances. IPCA inflation is hovering at over 8%, and will continue to face pressure during 2015 due to depreciation in the BRL and the increases in regulated prices. Inflation is expected to moderate in 2016 due to a favorable base effect, a tepid recovery, and tighter monetary policy, but will likely remain above the peer median. The current account deficit reached 3.9% of GDP in 2014 and is forecast to decline only gradually. While foreign direct investment flows have remained resilient thus far, downside risks are present. Increased external debt burden is also weakening Brazil's strong external balance sheet.

Brazil's fiscal accounts have deteriorated markedly over the past year, with the general government fiscal deficit reaching 6.5% of GDP in 2014, and the country recording its first primary deficit in several years. General government debt burden increased to 58.9% of GDP in 2014, compared to the average of 52.8% during 2010-2013. The debt burden is increasingly diverging from the 'BBB' median of 40% of GDP.

Fitch forecasts that general government deficits will remain elevated in 2015-2016 (averaging 5% of GDP) due to difficulties in achieving the primary surplus targets and increased interest-service burden. Moreover, economic recession in 2015 and a subdued recovery next year will continue to put upward pressure on the general government debt trajectory even under the assumption that that the Brazilian Treasury does not extend additional loans to BNDES (the Brazilian development bank). Economic under-performance, difficulty in implementing fiscal measures in a timely manner, and materialization of contingent liabilities represent downside risks for government debt dynamics.

The second administration of President Dilma Rousseff faces a challenging political mix characterized by record low popularity as well as a fragmented and confrontational Congress. The ongoing Petrobras corruption investigations have the potential to further contaminate the domestic political environment. As such, the government could confront challenges in progressing on its legislative agenda, which is important for it to meet its fiscal targets and restore broader confidence.

Brazil's 'BBB' IDRs are underpinned by the following key rating factors:

Brazil's economic diversity, relatively developed civil institutions, a strong shock-absorption capacity underpinned by a robust international reserves position, a net sovereign external creditor status, and an adequately capitalized banking system support its credit profile. In addition, the government's debt composition has improved in recent years, reducing currency and interest risks, and the sovereign maintains market access.

Despite a challenging economic and political environment, the country is embarking on a frontloaded macroeconomic adjustment process to improve consistency and credibility of policies, attesting to the capacity of policymakers to respond to shocks. The authorities have made relative price adjustments, allowed greater BRL depreciation, and are tightening monetary, fiscal and quasi-fiscal policies.

RATING SENSITIVITIES

The following risk factors individually, or collectively, could trigger a negative rating action:

--Continued economic under-performance, and difficulty in consolidating fiscal accounts. Crystallization of material contingent liabilities would be negative;

--Reduced confidence in the capacity of the government to sustain the currently underway fiscal and macroeconomic adjustment processes;

--A deterioration in Brazil's international reserves position and/or government debt composition.

The Outlook is Negative. Consequently, Fitch's sensitivity analysis does not currently anticipate developments with a high likelihood of leading to a positive rating change. Future developments that could individually, or collectively, result in a stabilization of the Outlook include:

--Improved consistency and credibility of economic policies that facilitates a reduction in macroeconomic imbalances and improves broader confidence;

--Fiscal consolidation that improves the government debt trajectory;

--A better investment and growth environment.

KEY ASSUMPTIONS

The ratings and Outlooks are sensitive to a number of assumptions:

--Fitch assumes a strong level of sovereign support for Petrobras. Fitch's base case does not assume that Petrobras' external market debt will be accelerated in 2015 although risks of such occurrence could grow if the company is unable to publish its 2014 year-end audited financial statements in a timely manner.

--Fitch does not include a scenario of electricity rationing in its baseline economic projections for 2015 and 2016.

--Fitch assumes that Brazil maintains international and domestic market access even if there is return of higher international financial volatility and further domestic confidence shocks.

--Global assumptions are consistent with Fitch's published 'Global Economic Outlook', including the subdued outlook for commodity prices.

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