Moody's Cuts Brazil's Ratings to 'Ba2'; Outlook to Negative (EWZ)

Moody's Investors Service has downgraded Brazil's issuer and bond ratings to Ba2 and changed the outlook to negative.

The downgrade was driven by

i) The prospect of further deterioration in Brazil's debt metrics in a low growth environment, with the government's debt likely to exceed 80% of GDP within three years; and

ii) The challenging political dynamics, which will continue to complicate the authorities' fiscal consolidation efforts and delay structural reforms.

The negative outlook reflects the view that risks are skewed toward an even slower consolidation and recovery, or further shocks emerging, which creates uncertainty over the magnitude of deterioration of Brazil's debt profile over the rating horizon.

RATINGS RATIONALE

RATIONALE FOR THE DOWNGRADE

Brazil's credit metrics have deteriorated materially since the Baa3 rating with a stable outlook was assigned in August 2015. That deterioration is expected to continue over the coming three years, given the scale of the shock to the Brazilian economy, the lack of progress made by the government in achieving its fiscal and economic reform objectives and the political dynamics expected to persist over that period. The downgrade to Ba2 is intended to captures that ongoing deterioration, while the negative outlook contemplates the risks of further deterioration to Brazil's credit profile emanating from macroeconomic shocks, deeper political dysfunction or the need to support government-related entities.

FIRST DRIVER -- DETERIORATING DEBT METRICS WILL RESULT IN A MATERIALLY WEAKER CREDIT PROFILE IN THE COMING YEARS

Macroeconomic and fiscal developments over the next two to three years are expected to produce a materially weaker credit profile. The government debt burden will continue to increase during 2016-18 and will likely exceed 80% of GDP before stabilizing. Growth dynamics will remain weak in the coming years increasing the pressure on fiscal policy. We expect GDP growth to average a negative 0.5% over the period 2016-18. Additionally, we expect interest rates to remain elevated in real terms, which will contribute to low debt affordability with interest payments accounting for more than 20% of government revenues.

SECOND DRIVER -- CHALLENGING POLITICAL DYNAMICS WILL COMPLICATE FISCAL CONSOLIDATION EFFORTS AND DELAY STRUCTURAL REFORMS

The rise in government debt will partly reflect the slow progress expected in achieving meaningful fiscal consolidation. Addressing Brazil's fiscal challenges will require significant political will and consensus to reverse the upward trend in public spending and stabilize the debt trajectory. The government is working to garner support in Congress for key reform bills, including to raise the minimum retirement age, improve fiscal flexibility, and reduce revenue earmarking. However, while discussion of structural reforms is a positive development, their approval by Congress will be difficult given the government's limited support in Congress and ongoing political challenges facing the President. And weak political support for the President and her administration offers little prospect of more far-reaching reforms over the rating horizon.

RATIONALE FOR THE NEGATIVE OUTLOOK

In Moody's view, progress in fiscal consolidation will be slow, and economic growth anemic, for the next two to three years. The Ba2 rating level builds in the assumption that the credit profile will deteriorate over that period. However, the negative outlook reflects the uncertainty surrounding the interaction between political, economic and financial dynamics in Brazil and in consequence the potential for additional shocks materializing, which would put further downward pressure on the sovereign credit profile. Additional shocks might relate to the impact of investor sentiment on the recovery in growth; to political events which lower still further the government's capacity to make progress on structural reforms; and/or to the crystallization of contingent liabilities on the government's balance sheet.

WHAT COULD MAKE THE RATING GO UP

An upgrade is very unlikely in the short-term, given the negative outlook and the deterioration in debt metrics expected over the rating horizon. However, positive pressure on the rating could emerge if the authorities were able to address structural imbalances that led to a persistent fiscal deterioration and the buildup of sovereign debt. Such an outcome would likely be associated with improved political dynamics that lead to the approval of structural reforms to reduce budgetary rigidities, revenue earmarking, and mandatory growth in various spending categories despite weak revenue performance. Reduced uncertainty about the magnitude of contingent liabilities migrating to the sovereign balance sheet, most likely from Petrobras, could also lead Moody's to stabilize the outlook.

WHAT COULD MAKE THE RATING GO DOWN

The rating could come under additional pressure if Moody's were to conclude that the deterioration in fiscal and debt metrics were likely to go beyond our baseline scenario and that the Brazilian authorities were unlikely to be able to achieve fiscal consolidation and address the structural fiscal imbalances that hinder the reversal of the buildup of public debt. A negative outcome would likely be associated with a collective failure on the part of the government and Congress to set out a credible stabilization and reform agenda over the next year, leading to further loss in investor confidence, erosion of external buffers, and a high level of political uncertainty.

COUNTRY CEILINGS

The long-term foreign currency bond ceiling was changed to Ba1, while the short-term foreign currency bond ceiling was changed to NP. The long-term foreign currency deposit ceiling was changed to Ba3, and the short-term foreign currency deposit ceiling changed to NP. The long-term local currency bond and deposit ceilings were lowered to A3.

Downgrades:

..Issuer: Brazil

.... Country Ceiling Bank Deposit Rating, Lowered to NP from P-3

.... Country Ceiling Bank Deposit Rating, Lowered to Ba3 from Baa3

.... Country Ceiling Rating, Lowered to NP from P-2

.... Country Ceiling Rating, Lowered to Ba1 from Baa2

..Issuer: Brazil, Government of

.... Issuer Rating (Foreign Currency), Downgraded to Ba2 from Baa3

.... Issuer Rating (Local Currency), Downgraded to Ba2 from Baa3

....Senior Unsecured Regular Bond/Debenture (Local Currency), Downgraded to Ba2 from Baa3

....Senior Unsecured Regular Bond/Debenture (Foreign Currency), Downgraded to Ba2 from Baa3

....Senior Unsecured Shelf (Foreign Currency), Downgraded to (P)Ba2 from (P)Baa3

Outlook Actions:

..Issuer: Brazil, Government of

....Outlook, Changed To Negative From Rating Under Review

GDP per capita (PPP basis, US$): 16,155 (2014 Actual) (also known as Per Capita Income)

Real GDP growth (% change): 0.1% (2014 Actual) (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec): 6.4% (2014 Actual)

Gen. Gov. Financial Balance/GDP: -6.1% (2014 Actual) (also known as Fiscal Balance)

Current Account Balance/GDP: -4.3% (2014 Actual) (also known as External Balance)

External Debt/GDP: 33.3% (2014 Actual)

Level of economic development: Moderate level of economic resilience

Default history: At least one default event (on bonds and/or loans) has been recorded since 1983.

On 23 February 2016, a rating committee was called to discuss the rating of Brazil, Government of. The main points raised during the discussion were: The issuer's governance and/or management, have materially decreased. The issuer's fiscal or financial strength, including its debt profile, has materially decreased. The systemic risk in which the issuer operates has materially increased. Other views raised included: The issuer's economic fundamentals, including its economic strength, have materially decreased. The issuer's susceptibility to event risks has not materially changed. An analysis of this issuer, relative to its peers, indicates that a repositioning of its rating would be appropriate.

The principal methodology used in these ratings was Sovereign Bond Ratings published in December 2015. Please see the Ratings Methodologies page on www.moodys.com for a copy of this methodology. The weighting of all rating factors is described in the methodology used in this credit rating action, if applicable.

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