Brazil Trip Notes – Slippery Samba

Eric Fine, Portfolio Manager Emerging Markets Fixed Income Investment Team

Eric Fine recently visited Brazil and observed firsthand the intertwined political and economic dynamics that continue to pressure the country’s overall health. As political scandal and credit downgrades make the headlines, the situation in Brazil appears to be worsening. While the long-term ramifications for Brazil remain uncertain, it’s difficult to ignore the precarious stability of the country today.

Brazil’s debt dynamic is deteriorating. Extremely large fiscal deficits are undermining what had heretofore been an anchor. As a result, further rating downgrades are possible and the real seems especially vulnerable.

The country’s economy is still contracting, making its current decline one for the history books. Credit appears virtually frozen at private and state banks and it is hard to see a growth rebound in the foreseeable future.

Politics are mixed. On the positive side, the political party of current President Dilma Rousseff (the PT party) appears unlikely to win the presidential election in 2018, and any moves toward impeachment could bring a positive market scenario forward. On the other hand, 2018 is a long time away and any future government will have to deal with the steadily building burden of higher debts and deficits.
One silver lining is the country’s external accounts. The country is a net external creditor, and the dramatic selloff of the real and the near-depression in the economy are contributing to a low current account deficit. This is not a theoretical positive – the country has been buying back its external debt.

Brazil’s fiscal deficits of roughly 10% of GDP are a profound headwind. Most importantly, if not reversed, we expect this will leave the country with gross public debt of over 80% of GDP by the end of 2017. For comparison, by our calculations, the public debt level at the end of 2014 was just under 60% of GDP. Most of the borrowing to finance these deficits will be in local currency, which we see as a constant source of pressure for the local bond market. The fiscal deficit also keeps upward pressure on inflation and inflation expectations, which further undermines the currency.

Credit is essentially frozen, with private banks in a defensive mode, and state banks constrained by the government’s fiscal situation and high domestic interest rates. One big difference between Brazil today and Brazil during its last major crisis (2002) is that households are now levered, meaning limited upside from domestic consumption. Although non-performing loans (NPLs) aren’t high yet, we believe we are entering a phase where they will begin to be recognized, and defaults on some corporates should be expected.

There are positives and negatives in the political sphere. In the minus column, opposition support for any political reform while President Rousseff is in office is unlikely, for the obvious reason that it would help her party. This matters because indexation of wages and social security benefits are very hard for even the opposition to support, perpetuating the underlying fiscal problem. In the plus column, the PT party is highly likely to be a non-factor in 2018 elections. In our estimation, Brazil’s electorate usually punishes presidents for generating adverse economic outcomes. If President Rousseff is impeached, moreover, this could bring such a scenario forward, though the impeachment process is complicated.

Still, Brazil has more hard-currency reserves than debt, and they use them. They have been buying back dollar debt, so the country’s net creditor status has very practical implications. This makes it difficult for us to have one overarching opinion on Brazil. We find the hard-currency debt of the sovereign and of quasi-sovereign entities such as Petrobras attractive, despite our concerns over local currency and the economy overall.

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