S&P Downgrades Rio de Janeiro to 'CCC-'; Outlook is Negative (EWZ)

August 25, 2016 8:05 AM EDT

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On Aug. 24, 2016, S&P Global Ratings lowered its long-term issuer credit rating on the state of Rio de Janeiro (Rio) to 'CCC-' from 'B-'. At the same time, we lowered our national scale rating on the state to 'brCCC-' from 'brB-'. We also removed ratings from CreditWatch negative, where we placed them on May 30, 2016. The outlook is negative.


The downgrade reflects the heightened risk of default given that we now detect more uncertainties over Rio's debt payments coming due within the next six months. Because of Rio's weak liquidity position, its capacity to pay the estimated R$2.5 billion in debt service within the next six months (R$1.5 billion in interest and around R$1 billion in amortization payment) is doubtful. According to "Criteria For Assigning 'CCC+', 'CCC', 'CCC-', And 'CC' Ratings," a default, distressed exchange, or redemption appears to be inevitable within six months, absent unanticipated, significantly favorable changes in the issuer's circumstances.

Among others debt payments, the state will be facing debt service totaling R$164 million for its outstanding loan from Credit Suisse in September and October of 2016, which the federal government fully guarantees. If Rio misses the payment on this loan on its due date and we don't believe payment is likely within the next five business days (either by the state or the federal government) we would downgrade the state to 'SD' (selected default).

Out of total debt, Rio owes 67% of it to the federal government, 19% to public banks, and 12% to multilateral lending agencies and commercial banks as of June 2016. The sovereign guarantees the majority of Rio's debt. Under the guarantee mechanism, the state relinquishes ownership on all of its revenue--own tax revenue or the transfers it's entitled to receive from the central government according to the constitution, until repayment of the state's debt has occurred and the central government decides to release the remaining funds. We believe the national treasury will continue to cover Rio's debt service on time, according to terms and conditions of the loan contracts. However, if either level of the government fails to pay the obligation within the stated grace period (or five business days if there is no stated grace period), we would downgrade Rio to 'SD', according to our General Criteria: Methodology: Timeliness Of Payments: Grace Periods, Guarantees, And Use Of 'D' And 'SD' Ratings, Oct. 24, 2013. This would occur even if the central government makes the payment under the guarantee mechanism established in the loan contracts.

In addition, the state has several loans from public banks—the Brazilian Development Bank (BNDES) and Banco do Brasil. However, we consider all credit lines from these lenders as intergovernmental transfers because they represent loans from government-related entities (GREs). We don't consider as a default the failure to pay intergovernmental obligations that a non-U.S. local and regional government (LRG) owes to either the central or regional government, or to public-sector enterprises related to the LRG or to the central government.

The ratings on Rio reflect a deep financial stress, as seen in fiscal data as of June 2016, a deteriorating cash position, and greater uncertainty over the state's capacity and willingness to make full and timely payments on its financial obligations. However, we believe that the institutional framework in Brazil, though confronting increasing risks, continues to provide support to Brazilian LRGs including Rio at the current rating level. In addition, the framework's level of predictability, transparency, and accountability corresponds to our assessment as evolving and unbalanced. The prevailing weakening trend in Brazil's institutional framework reflects its fiscal challenges for Brazilian states' ability to ensure medium- and long-term fiscal sustainability.

Between May and July 2016, Rio missed service payments of guaranteed debt to bilateral and multilateral agencies and the Brazilian government-owned banks totaling R$535 million. On this and other similar occasions, the central government stepped in and serviced debt on Rio's behalf. As long as the intergovernmental relations in Brazil and agreements continue prioritizing debt repayment while LRGs adhere to the Fiscal Responsibility Law, we believe the institutional framework isn't likely to deteriorate further.

The framework that defines intergovernmental relationships in Brazil displays a wide array of ongoing support mechanisms that the central government provides to the LRGs. We would typically consider as systemic ongoing support a well-established legal framework that enables the central government to honor LRG's financial obligations on a timely basis, either as a direct transfer to creditors or by providing cash to an LRG prior to upcoming maturities, or by diverting the latter's cash (either own revenues or transfers from the central government). As one of the alternatives, the central government may use the LRG's own revenue (tax revenue, shared revenue, and transfers), and/or use some of the transfers owed to the LRG under the general framework; such latter payment being subsequently deducted from the next installment. In such cases, we view as not a meaningful distinction whether the central government pays directly to the creditor (to then be reimbursed by the LRG), or gives support to the LRG in advance, in order for the LRG to make the payment directly to the creditor.

We had previously stated that we didn't consider missed payments from a LRG to a non-domestic official entity as a default. Such statement is inconsistent with our criteria. However, this hasn't impacted on the rating, given the institutional framework in Brazil as stated above.

Rio's plummeting liquidity position reflects the deepening of the state's fiscal crisis, which culminated in the declaration of financial emergency in early June. At the same time, Rio received R$2.9 billion in extraordinary support from the federal government to fund expenses related to the Olympic Games preparation, particularly for security. This action underscores central government's support. In the first half of 2016, Rio's revenue collection declined 22%, widening the operating deficit to 34% of operating revenue.

We expect Rio to continue posting very weak budgetary performance. We estimate that the state's operating deficit will reach at least R$8.4 billion or 17% of operating revenues in 2016 and maintain similar deficits over the next 12-18 months, depending on Rio's capacity to implement fiscal reforms. Deficits after capital expenditures are likely to be close to 21% of total revenue, depending on the state's capacity to cut and postpone investments.

We view Rio's budgetary flexibility as weak. Although own-source revenues account for around 90% of the state's operating revenues, Rio has limited ability to cut expenditures due to high share of operating spending as well as large-scale infrastructure projects. According to our base-case scenario for 2016, the state's budgetary flexibility will remain weak due to difficulties in controlling operating spending amid an economic recession that's squeezing Rio's tax revenue collection.

Rio's tax-supported debt is very high, reflecting the decrease in revenues while debt in absolute terms has remained relatively unchanged. Our base case for 2016 assumes Rio's tax-supported debt to be about 215% of consolidated operating revenue. The state owes almost 70% of its debt to the federal government, and our projections incorporate the potential outcome of the current debt renegotiation between the central government and LRGs, which could trim debt service payments of the latter in the next two years.

Even during a recession, Rio's GDP per capita continues to be higher than that of other Brazilian states such as Minas Gerais. Overall, we consider Rio's economy as weak compared with that of international peers. According to our estimates, Rio's GDP per capita was around $12,817 in fiscal 2015.

Rio has moderate contingent liabilities because most of GREs are part of the state's budget and debt, including cross-default clauses in BNDES' debt agreements with GREs. Companhia Estadual de Aguas e Esgotos, a sewage and water utility, is Rio's largest-owned entity, which we consider as self-supporting.


We view the state's liquidity as weak because Rio has no free cash (cash that's not required to meet daily operating needs or planned capital costs) and its internal cash flow generation capability is limited due to a deficit after capital accounts of about 21% of total revenue in 2016. Because of Rio's weak liquidity position, we view the state's capacity to pay the estimated R$2.5 billion in debt service within the next six months as doubtful.


The negative outlook on Rio reflects the likelihood of a further downgrade based on increasing risk of delayed debt service payments. If either the federal government or Rio fails to make upcoming debt service payments during the next six months, we would downgrade Rio to 'SD'.

We could revise our outlook on the state to stable if risks to debt servicing were to unexpectedly diminish, combined with a sustainable financial and fiscal plan that boosts liquidity to meet debt obligations over the medium term. However, such a scenario is unlikely in the next six months.


Table 1

Economic Statistics
Population growth (%)
GDP per capita (local currency) (single units)31,80035,35438,26240,71242,680
Real GDP growth (%)
Unemployment rate (%)N/A7.
The data and ratios above result in part from S&P Global Ratings' own calculations, drawing on national as well as international sources, reflecting S&P Global Ratings' independent view on the timeliness, coverage, accuracy, credibility, and usability of available information. Sources typically include national statistical offices.

Table 2

Financial Statistics
(Mil. R$)
Operating revenues52,46455,06058,04657,70951,39950,49353,06656,735
Operating expenditures47,77853,08558,41060,01552,08558,98962,20364,941
Operating balance4,6871,975(364)(2,306)(686)(8,496)(9,137)(8,206)
Operating balance (% of operating revenues)8.93.6(0.6)(4.0)(1.3)(16.8)(17.2)(14.5)
Capital revenues1,4875462,1855,7501,4651,5221,5811,643
Capital expenditures4,9555,5217,1457,7566,7043,9793,7573,679
Balance after capital accounts1,218(3,000)(5,324)(4,312)(5,925)(10,953)(11,312)(10,242)
Balance after capital accounts (% of total revenues)2.3(5.4)(8.8)(6.8)(11.2)(21.1)(20.7)(17.5)
Debt repaid1,6312,2262,8323,4503,4508632,6923,764
Balance after debt repayment and onlending(413)(5,226)(8,156)(7,762)(9,376)(11,816)(14,004)(14,006)
Balance after debt repayment and onlending (% of total revenues)(0.8)(9.4)(13.5)(12.2)(17.7)(22.7)(25.6)(24.0)
Gross borrowings1,4524,9698,57411,6055,3062,7812,677949
Balance after borrowings1,039(257)4183,843(4,070)(9,035)(11,327)(13,057)
Operating revenue growth (%)
Operating expenditure growth (%)12.411.110.02.7(13.2)
Modifiable revenues (% of operating revenues)89.189.690.790.389.588.288.388.6
Capital expenditures (% of total expenditures)9.49.410.911.411.
Direct debt (% of operating revenues)122.2135.2137.3155.7209.3215.8206.0188.9
Tax-supported debt (% of consolidated operating revenues)122.2135.2137.3155.7209.3215.8206.0188.9
Interest (% of operating revenues)
Debt service (% of operating revenues)

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