Thursday, 21 March 2019

A darling debauched

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Brazil’s dire economy and the fallout from the Petrobras scandal have left it clinging to its investment-grade status.

Brazil is hosting the 2016 Olympics but it won’t be winning any medals for the performance of its economy, which has tumbled into recession while the country fights to retain its investment-grade status.

It’s a battle it seems destined to lose, after S&P downgraded it to junk on September 9. Should Moody’s or Fitch follow suit, then Brazil will have officially lost the investment-grade status it has held since 2008.

The S&P downgrade to BB+ from BBB – came after Brazil posted its worst fiscal results in 18 years on August 28, when official figures confirmed that the country had entered recession after its economy contracted by 1.9% between April and June, compared with the previous three months.

Days later, Brazilian credits took a beating after President Dilma Rousseff submitted a bill to Congress on August 31 that predicted a fiscal deficit for the first time, after repeatedly saying previously that the economy would preserve its surplus.

Rousseff proposed a 2016 budget bill that forecast a primary deficit of the non-financial public sector of 0.34% of GDP, compared with an earlier forecast that predicted a surplus of 0.7% in 2016.

After failing to manage expectations about the state of its finances, this latest move suggests Rousseff’s regime has finally got a dose of reality.

“It keeps making assumptions that are not realistic and fails to have a worse-than-priced in growth outlook,” said Danny Tenengauzer, RBC’s head of emerging markets research and global FX strategy.

The country’s fall from the grace, from BRIC darling to brink of collapse, has been swift and deeply damaging. Under Rousseff, Brazil has racked up a deficit where debt stands at 70% of GDP. Rousseff still has three years of her term to run, but her approval rating of 8% is the lowest of any leader. The country has been racked by the scandal at state-run Petrobras, which Rousseff used to run, raising the spectre of her being impeached.

The currency has plummeted, bond yields are rising, and the local stock market has given up its 2015 gains.

“Brazilian assets will continue to underperform until the downgrade is announced, which I expect to be during the first or second quarter of 2016,” said Tenengauzer.

The county’s five-year CDS has spiked to 350bp as price dynamics have deteriorated to reflect a more significant chance of Brazil going sub-investment grade.

Jan Dehn, head of research at Ashmore, said: “Brazil has a major political scandal rooted in corruption taking place at the exact time when the country needs to take austerity measures. Add in the prospect of US rate hikes and falling commodity prices, and the country is in dire straits.”

A matter of time

The country’s descent to junk appears only to be a matter of time. The question now is how long it will be before other agencies follow suit, as a second downgrade to junk would force foreign pension funds and other large investors to unload bonds. JP Morgan research said that in the event of a second downgrade, passive investors would be forced to sell US$1.5bn of foreign debt issued by Brazilian companies and US$800m of sovereign debt.

Tenengauzer says that the main implication from S&Ps’ action will “likely be additional downgrades in the private sector”. Petrobras CDS is now 766bp against 232bp a year ago, while mining company Vale CDS is 526bp against 215bp, according to Tenengauzer.

On August 11, Moody’s lowered Brazil’s government bond rating to Baa3 from Baa2, citing weak economic growth and rising government spending.

In July, Joaquim Levy, Rousseff’s new finance minister, cut his projection of the size of the country’s fiscal surplus, slashing it to 0.15% of GDP from 1.1% in 2015, while for 2016 it was revised downward to 0.7% from 2%.

The country has suffered capital outflows while the Real has weakened by 23% this year, placing it among the worst performing currencies.

Soumyanshu Bhattacharya, an institutional portfolio manager for the emerging markets sovereign team at BlueBay Asset Management, said: “As a result, investors are underweight Brazil and it is ripe for a rebound. At the short end of the currency curve interest rates are at 14.88%, one of the most attractive from an investor perspective anywhere.”

But the government does not benefit in a country that has two interest rates. There is the official one, and the so-called TJLP, the subsidised rate at which state development bank BNDES pegs its loans.

Rousseff has raised it in an attempt to reduce subsidies that have eroded the country’s finances, but even with the increase it stands at 6.5%.

“That means Brazilian companies can borrow money at 6.5% then invest in government bonds at 14.5%. It’s a massive carry trade and the government is on the other side of it,” said one Brazil-based banker.

Glimmer of hope

There is a glimmer of hope that is keeping Brazil from the abyss. When Moody’s issued its latest downgrade, it changed its outlook to stable from negative, citing the country’s “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”.

Brazil is less exposed to falling commodity prices than neighbouring Chile, while the plummeting stock market in China will have been factored into the Fed’s thinking when considering rate hikes. 

Dehn said: “The question for investors is whether Brazil will go bust and I don’t think it will. It still has relative flexibility – it has a healthy cushion of foreign exchange reserves, and it still has the ability to go to the IMF.”

Despite her parlous popularity ratings, Rousseff is weathering the storm. The corruption scandal has not reached her and she has begun to take action, providing US$4bn in credit from state-run banks to boost local industries, particularly carmakers.

Meanwhile, on August 19, Brazil’s Senate approved one of Rousseff’s key austerity measures, a bill to roll back payroll tax breaks and help reduce the fiscal deficit and restore confidence in her government’s accounts.

“Dilma and her economic team are gradually getting to grips with implementing some economic reforms within the political constraints and we don’t expect another downgrade either from Moody’s or S&P in the next six to nine months, said Bhattacharya.

The fallout from the Petrobras scandal, in which senior Brazilian politicians and former company executives stand accused of conspiring with construction companies in return for kickbacks and bribes, is being keenly felt.

Three building companies – OAS SA, Galvao Engenharia and Grupo Schahin – have already filed for bankruptcy protection for some of their units after the allegations pulled the plug on their access to bond financing.

The scandal has now engulfed Odebrecht, Latin America’s largest construction group, which stands accused of cheating Petrobras out of US$1.9bn. Moody’s has warned that the case could jeopardise some of Odebrecht’s US$34bn backlog of construction contracts.

S&P said the economic slowdown in 2015 was in part due to “a decline in investment from Petrobras and its supply chain in the construction sector”, as well as fiscal and monetary tightening. The state-owned oil company has slashed its five-year investment plan to US$130bn from US$220bn. But within that could lie Rousseff’s salvation.

“The more the pain is felt, the more people will want a quick fix, rather than a prolonged corruption investigation,” said Bhattacharya.

The market volatility emanating from China that hit emerging markets in August is not helping, but amid all the gloom – and with a downgrade seemingly now just a matter of time – there are some silver linings, including an improvement in the current account as a result of a collapse in consumer spending and investment.

Dehn said: “The external balances are already improving due to a weaker currency and policy adjustments. Inflation is likely to collapse over the coming year, paving the way for rate cuts. As the economy bottoms out, the public finances will also stabilise. A juicy bond trade is therefore in the making. The main challenge for herd-like investors will be to do that which they always find so difficult, namely to buy when it is cheap.”

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