Moody's Downgrades Brazil to 'Baa3'; Outlook Raised to Stable (EWZ)

Moody's Investors Service has today downgraded Brazil's government bond rating to Baa3 from Baa2. The rating agency also changed the outlook on the rating to stable from negative

The drivers of the rating change are:

1. Weaker-than expected economic performance, the related upward trend in government expenditures and lack of political consensus on fiscal reforms will prevent the authorities from achieving primary surpluses high enough to arrest and reverse the rising debt trend this year and next, and challenge their ability to do so thereafter.

2. As a result, government debt burden and debt affordability will continue to deteriorate materially in 2015 and 2016 relative to the rating agency's prior expectations, to levels materially worse than Brazil's Baa-rated peers. Moody's expects the rising debt burden to stabilize only towards the end of this administration.

In Moody's view, Brazil retains a number of credit strengths that are reflected in its Baa3 rating: its ability to withstand external financial shocks given ample international reserve buffers; a government balance sheet with relatively limited exposure to foreign currency debt and non-resident debt holdings compared with its peers; and a large and diversified economy.

In addition to downgrading Brazil's government bond rating, Moody's also downgraded its senior unsecured debt rating to Baa3 from Baa2, and the senior unsecured shelf rating to (P)Baa3 from (P)Baa2. The rating agency also changed Brazil's foreign currency country ceilings as part of this rating action. The foreign currency bond ceiling went to Baa2 from Baa1, while the foreign currency deposit ceiling went to Baa3 from Baa2. The local currency country ceilings were not affected.

RATINGS RATIONALE

RATIONALE FOR THE DOWNGRADE TO Baa3

FIRST DRIVER - WEAK ECONOMIC GROWTH, INCREASED GOVERNMENT SPENDING AND A LACK OF POLITICAL CONSENSUS WILL LIMIT THE AUTHORITIES' ABILITY TO ARREST AND REVERSE DEFICIT AND DEBT TRENDS

It will be challenging for Brazil to achieve and sustain improving fiscal trends. Last month the government revised its macroeconomic projections. The numbers confirm that the authorities have been unable to deliver primary surpluses large enough to prevent an increase in debt ratios in 2015-16, and face significant challenges in achieving the targets set in the medium-term fiscal program. Moody's estimates that GDP growth of at least 2% and primary surpluses of at least 2% of GDP will be required to stabilize debt ratios. The rating agency does not expect Brazil to meet these conditions this year or next.

Growth has been even weaker than Moody's expected a year ago, and will remain so, in the agency's view. Fiscal and monetary policy tightening, along with weak consumption and investment spending, will negatively impact economic growth in 2015-16, with the expectation of a recession in 2015, a stagnant economy next year, and a gradual post-2016 recovery with GDP growth reporting annual rates of about 2% in 2017-18.

Consumption has been hit by adverse labor market conditions with declining employment and a reduction in real wages negatively affecting household spending. Moody's expects these conditions to extend into 2016 given the lag between when labor market indicators respond and the economic cycle. At the same time, low capacity utilization, low business confidence, and Petrobras-related developments will negatively affect investment prospects this year and next.

There is a lack of political consensus in Brazil over whether to more aggressively address budgetary rigidities by pushing reforms that tackle mandatory spending increases. This political stalemate will make it difficult to arrest government spending trends and, consequently, to reverse the rising debt trend during the second part of this administration. The political arena has become increasingly complicated. Record-low approval ratings for President Rousseff have weakened her political standing and the legal proceedings of the Lava Jato corruption investigation have contributed to increased tension between Congress and the Executive Branch, further undermining the government's efforts to advance its economic agenda.

On the fiscal front, the reduction in discretionary spending has not adequately compensated for the impact that weaker-than-expected growth has had on government revenues. This trend will continue, particularly in light of mandatory expenditures that continue to increase in real terms.

During the year Congress approved several fiscal measures that have been submitted by the government, but Moody's expects significant opposition to a key upcoming vote on the reversal of payroll tax reductions. A negative outcome that results in a significantly watered-down version of the original proposal could compromise next year's fiscal targets.

SECOND DRIVER -- DEBT METRICS TO DETERIORATE MATERIALLY RELATIVE TO Baa-RATED PEERS

As a result, Moody's expects government debt ratios to continue to increase over the course of this administration, remaining at historically high levels both in absolute terms and relative to Brazil's Baa peer group. Debt affordability will continue to decline, in absolute terms and relative to peers.

Moody's estimates that debt-to-GDP will rise to 67% in 2016 and continue to rise slowly thereafter, reaching close to 70% in 2018 -- in both cases significantly higher than the 53% level reached in 2013. Thereafter, the rating agency expects debt levels to remain around that elevated level. The interest burden will also be materially higher, with interest payments exceeding 20% of government revenues in 2015 and 2016 compared with 16% in 2013. Moody's forecasts assume that economic growth and the primary surplus both rise to 2% during the second part of this administration. It would take higher growth or a more significant fiscal correction than currently incorporated into Brazil's revised official scenario to reverse the rising debt trajectory before the end of this administration. Conversely, lower growth or a lower surplus would imply that debt levels would continue to rise beyond the end of this administration.

As a consequence, Brazil's fiscal profile will remain weaker than that of other Baa-rated sovereigns, with debt-to-GDP and interest-to-revenue ratios well above medians for Baa-rated peers. Brazil's fiscal strength has been deteriorating relative to peers for some years, and Moody's expects it to continue to do so for the rest of this administration's term.

RATIONALE FOR THE ASSIGNMENT OF A Baa3 RATING

The assignment of a Baa3 rating reflects a balance of strengths and weaknesses.

Brazil possesses a large, diverse economy, which is a credit strength. Despite the deterioration in credit metrics that underpins today's action, Brazil has low susceptibility to event risk, a comparative advantage relative to sovereign peers with Baa ratings. The government's balance sheet has very limited foreign currency exposure and low non-resident domestic debt holdings. Current account deficits are manageable, being largely financed by foreign direct investment inflows, and international reserves provide ample coverage of external debt payments. In all of these areas, Brazil's standing is comparable to, or stronger than, that of several Baa- and A-rated peers.

Set against those external strengths, the government's debt burden is high relative to Baa peers and continues to rise. Growth is low and debt affordability is declining. Institutional strength -- the ability of Brazil's institutions to agree and deliver credit-supportive policy objectives -- is under pressure. Political dynamics are damaging: the lack of political consensus on fiscal reforms has been exacerbated by the events surrounding the Lava Jato investigation and Petrobras-related corruption scandals. That, in turn, has contributed to the sustained loss of investor confidence.

At present, Brazil's strengths sufficiently protect the government's balance sheet from shocks during the period of adjustment and recovery for its economic and fiscal profile to continue to support an investment-grade rating. However, much will rest on the capacity of Brazil's institutions to achieve fiscal and monetary objectives, and its ability to restore investor confidence and to stimulate growth.

RATIONALE FOR THE ASSIGNMENT OF A STABLE OUTLOOK

The assignment of a stable outlook reflects Moody's view that Brazil possesses the ability to achieve a turn-around in growth and fiscal performance. The risks of political dysfunction leading to further economic and fiscal deterioration and the likelihood of a faster-than-expected economic and fiscal recovery are broadly balanced. Even though Moody's expects the economic environment to remain poor and political dynamics to remain relatively unstable in 2015 and 2016, the rating agency does not currently expect so severe a deterioration in debt metrics as to threaten Brazil's investment-grade rating.

A macroeconomic environment characterized by economic contraction, high inflation and elevated interest rates will continue to pose challenges to the authorities this year and next. Because these conditions reflect to a large extent cyclical factors, Moody's expects that conditions will improve during the second part of 2016, alleviating the pressure on government accounts. While political dynamics will likely remain complicated on account of President Rousseff's record-low approval ratings, which will continue to restrict the government's ability to advance its economic agenda in Congress, Moody's does not expect that to compromise fiscal sustainability over the medium term.

The stable outlook also reflects Moody's view that Brazil's overall credit profile is more closely aligned with that of Baa3 peers than with representative Ba1-rated sovereigns.

WHAT COULD MAKE THE RATING GO UP

The rating could go up, or the outlook be revised to positive, should Moody's conclude that Brazil's economic and fiscal prospects are likely to stabilize and ultimately improve faster or with greater assurance than currently expected. Such an outcome would likely be associated with fiscal reforms that reduce structural budgetary rigidities derived from revenue earmarking and mandatory growth in various spending categories.

WHAT COULD MAKE THE RATING GO DOWN

The rating could come under additional pressure if government debt metrics were to deteriorate further and faster than Moody's expects, and if the rating agency were to conclude that Brazil was unlikely to achieve the growth and fiscal consolidation needed to ensure fiscal sustainability over the medium term. In Moody's view, Brazil needs to achieve GDP growth and primary surpluses of at least 2% of GDP during the second part of this administration to arrest the rise in debt and provide assurance of fiscal sustainability beyond the span of this administration. A negative outcome would likely be associated with a collective failure on the part of Brazil's fiscal and monetary authorities to set out and achieve clear, supportive policy objectives coupled with a higher-than-expected level of political instability.

GDP per capita (PPP basis, US$): 16,096 (2014 Actual) (also known as Per Capita Income)

Real GDP growth (% change): 0.2% (2014 Actual) (also known as GDP Growth)

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

Gen. Gov. Financial Balance/GDP: -6.7% (2014 Actual) (also known as Fiscal Balance)

Current Account Balance/GDP: -4.5% (2014 Actual) (also known as External Balance)

External debt/GDP: 26.8% (Actual)

Level of economic development: High level of economic resilience

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

On 07 August 2015, a rating committee was called to discuss the rating of the Brazil, Government of. The main points raised during the discussion were: The issuer's economic fundamentals, including its economic strength, have materially decreased. The issuer's fiscal or financial strength, including its debt profile, has materially decreased. Other views raised included: The issuer's susceptibility to event risks has not materially changed.

The principal methodology used in these ratings was Sovereign Bond Ratings published in September 2013. Please see the Credit Policy 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 rating action, if applicable.

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