Moody's Lowers Outlook on Brazil to Negative (EWZ)

Moody's Investors Service has today changed the outlook on Brazil's Baa2 government bond rating to negative from stable. The change of outlook applies to all rating classes for "Brazil, Government of", i.e. issuer ratings, government bond ratings and shelf ratings. The foreign currency and local currency country ceilings remain unchanged.

The rating action reflects the rising risk that sustained low growth and worsening debt metrics indicate a reduction in Brazil's creditworthiness, which would trigger a downward migration in its credit rating.

The drivers of the outlook change are:

1. A sustained reduction in Brazil's economic growth, which shows little sign of a return to potential in the near term;

2. A marked deterioration in investor sentiment which has negatively impacted fixed capital formation in Brazil; and

3. The fiscal challenges these economic headwinds pose, impeding the reversal of the upward trend in government debt indicators

At the same time, Moody's has affirmed Brazil's government bond rating at its current Baa2 level on account of the country's continued resilience to external financial shocks given its international reserve buffers; the government balance sheet's limited vulnerability to sudden changes in global risk appetite compared with its peers; and the underlying credit benefits derived from Brazil's large and diversified economy.

RATIONALE FOR OUTLOOK CHANGE TO NEGATIVE

- GROWTH HAS DECLINED SHARPLY WITH LITTLE PROSPECT OF RETURNING TO POTENTIAL IN THE NEAR TERM

The first driver of Moody's decision to change the outlook on Brazil's Baa2 sovereign rating to negative is the country's weakened near-term growth prospects, on top of sustained low economic growth over the past four years, which has been further compounded by the recent recession. Moody's expects that Brazil's economy will continue to record low growth, and estimates that annual GDP increases are likely to remain below the country's potential of around 3%. Specifically, Moody's forecasts that Brazil's GDP is likely to expand by less than 1% in 2014 -- which would be the lowest annual rate since 2009 -- and that 2015 growth will remain below the 2% mark.

While other Latin American countries have also recorded declining growth rates, Brazil's economic slowdown has been more pronounced and prolonged, which Moody's believes are due to idiosyncratic factors that mostly reflect domestic weaknesses.

Given the absence of any signs of a recovery, Moody's believes that Brazil's next administration will face depressed economic conditions. A continuation of persistently weak growth rates could further erode Brazil's fiscal position and materially undermine its credit profile.

- A MARKED DETERIORATION IN INVESTOR SENTIMENT HAS NEGATIVELY IMPACTED FIXED CAPITAL FORMATION

The second driver supporting Moody's decision to change Brazil's rating outlook to negative is declining fixed capital formation, which reflects in good part negative investor sentiment driven by widespread market perception about the interventionist approach of the current administration. Confidence indicators are at record lows, with reported levels similar to those observed in 2008-09 during the global financial crisis.

Moody's observes that Brazil has been an outlier within its peer rating group, with investment ratios of around 18% of GDP compared with a Baa median of more than 23%. Given this lower ratio, Brazil's quarter-on-quarter declines in gross fixed capital formation during nine of the past 12 quarters is a negative credit development.

Moody's believes that weak business confidence and investment will pose headwinds for an economic recovery given limited prospects of a reversal in investors' sentiment. In the absence of stronger private investment, a sustained recovery in economic activity is unlikely to take hold.

- WORSENING FISCAL METRICS AND ECONOMIC HEADWINDS POSE CREDIT CHALLENGES TO THE INCOMING ADMINISTRATION

The third driver informing the change in Brazil's rating outlook to negative are headwinds that will exacerbate the medium-term fiscal challenges facing the next government, whoever leads it. The primary surplus has been declining consistently since 2011. Moody's expects government debt metrics could deteriorate further in view of declining primary surpluses in the context of low GDP growth and higher interest rates.

If persistently weak growth is not reversed, this condition will further erode Brazil's fiscal position and materially undermine its credit profile, raising the prospect of further deterioration in government debt metrics and diminution in the government's financial strength.

While Moody's considers it likely that any incoming administration will introduce policy measures intended to reverse the growth trajectory, the negative outlook reflects the increasingly challenging task facing the next government.

At nearly 60% of GDP, Brazil's government debt ratios already compare unfavorably with the Baa median of 39%. If current trends remain unchecked, debt indicators will rise to levels that are not only inconsistent with its current ratings, but that could be at odds with those of Brazil's Baa peer group.

RATIONALE FOR AFFIRMING RATING AT Baa2

The affirmation of Brazil's Baa2 rating reflects a number of core credit strengths, including: the country's continued resilience to external financial shocks given its international reserve buffers; the government balance sheet's limited vulnerability to sudden changes in global risk appetite compared with its peers; and the underlying credit benefits derived from Brazil's large and diversified economy.

Moody's notes that Brazil's credit resilience to event risk remains strong on account of (i) an international reserve buffer that provides ample cover against external financial shocks; (ii) a government balance sheet that incorporates limited exposure to foreign currency-denominated debt and non-residents relative to peers; (iii) and a banking system that, in spite of low economic growth, continues to report relatively high capital and liquidity ratios and a low level of non-performing loans.

Moody's decision to affirm the rating incorporates an expectation that, despite perceived differences in the policy proposals of the three leading candidates, the next administration will likely place particular emphasis on (i) a return to a more conservative fiscal stance, and (ii) the adoption of measures that investors are likely to view as conducive to a more market-friendly business environment, which would allow growth to move closer to Brazil's potential.

However, any adjustment will take time to take effect. Accordingly, Moody's believes the economy is likely to go through a one- to two-year transition period after the new administration takes office on 1 January 2015 and that a possible reversal of current trends would only occur gradually, regardless of which candidate is elected.

WHAT COULD MOVE THE RATING UP/DOWN

Moody's would consider downgrading Brazil's sovereign rating if there are indications that (1) the trend in fiscal and government debt metric is unlikely to be arrested and reversed; and (2) GDP growth will remain in the 1%-2% range, evidencing a more entrenched downward shift in growth.

Should the deterioration in the country's key credit metrics, in particular fiscal and government debt indicators, remain unchecked during the first two years of the incoming administration, this can significantly undermine Brazil's sovereign creditworthiness potentially initiating a downward migration of Brazil's Baa2 rating.

Even though an upgrade is unlikely over the coming 1-2 years, Moody's would consider moving the outlook on Brazil's sovereign rating back to stable in the event of (1) a consolidation of an investment-led economic recovery; and (2) strict compliance with primary surplus targets in the 2%-3% GDP range. Moody's would view the introduction of a fiscal framework that incorporates explicit rules designed to curb growth in primary current expenditures as a necessary prerequisite for a rating upgrade .

GDP per capita (PPP basis, US$): 12,221 (2013 Actual) (also known as Per Capita Income)

Real GDP growth (% change): 2.5% (2013 Actual) (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec): 5.9% (2013 Actual)

Gen. Gov. Financial Balance/GDP: -3.7% (2013 Actual) (also known as Fiscal Balance)

Current Account Balance/GDP: -3.6% (2013 Actual) (also known as External Balance)

External debt/GDP: 23.5% (2013 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 05 September 2014, a rating committee was called to discuss the rating of Brazil, Government of. The main points raised during the discussion were: The issuer's economic performance has materially deteriorated. The issuer's fiscal or financial strength, including its debt metrics, has been negatively impacted.

The principal methodology used in this rating 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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