For Brazil and The Other BRIC Countries, Credit Quality Is About More Than Just Size

November 4, 2010
For Brazil And The Other BRIC Countries, Credit Quality Is About More Than Just Size
Primary Credit Analyst: Sebastian Briozzo, Buenos Aires (54) 11 4891 2120; sebastian_briozzo@standardandpoors.com Secondary Credit Analyst: Joydeep Mukherji, New York (1) 212-438-7351; joydeep_mukherji@standardandpoors.com
Table Of Contents
Economic Structures: Differ Significantly Across The BRICs Fiscal Flexibility: High Debt And Interest Payments Put Brazil In A Weaker Position Relative To Most Of Its Peers Monetary Flexibility: Strengthening In Brazil External Indicators: A Common Strength Among The BRIC Countries Brazil's Stronger Political System Helps To Offset Fiscal Weaknesses
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Only five countries in the world are larger than 2 million square kilometers, have more than 100 million inhabitants, and have GDP of more than $600 billion, as highlighted in a presentation by the Central Bank of Brazil. The U.S. is one. The others are Brazil, Russia, India, and China--the BRICs. Other than their size, the BRIC countries have little in common in terms of their main economic indicators, which Standard & Poor's Ratings Services analyzes to determine its credit ratings on the sovereigns. Size is indeed important. Large economies have greater absolute levels of debt available to investors, which keeps the markets liquid--a key strength in times of uncertainty and volatility. However, the BRIC economies have fairly different structures and vulnerabilities when it comes to measuring their economic, fiscal, and monetary flexibility. The one exception is external flexibility, which is, for the most part, a significant credit strength for each of the sovereigns. In our view, Brazil (BBB-/Stable/A-3) is weaker than its peers in some respects--especially with regard to its fiscal flexibility--but its strong and stable political system helps to offset the weaknesses.
Economic Structures: Differ Significantly Across The BRICs

When analyzing the BRIC countries' economies, there are some obvious similarities between China (A+/Stable/A-1+) and India (BBB-/Stable/A-3) as well as between Brazil and Russia (BBB/Stable/A-3). The Asian countries have rapidly growing economies (see chart 1) and limited availability of natural resources, and they're net importers of commodities. Brazil and Russia (and, to some extent, Mexico) have relatively wealthier economies and an abundance of natural resources, but they have lower growth. (We included Mexico in our comparisons given its relative importance as the second-largest economy in Latin America.) There is, of course, a strong relationship between GDP growth rates and initial levels of wealth (see chart 2). Brazil, Mexico, and Russia maintain GDP per capita levels that are substantially higher than those of China and India, despite the strong economic performance of these two economies.
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Chart 1
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Chart 2
The significantly higher levels of investment in China and India support the countries' stronger economic performances. In addition, the Asian countries have higher domestic saving rates than Latin American countries. Cultural considerations often are a factor in any society's decisions to save or consume, but a long history of monetary stability and the absence of inflation fears in China and India set the context for a greater saving rate in these two countries. This is in contrast to Brazil, where--despite recent improvements--the willingness of Brazilians to put their capital into long-term savings instruments remains limited. Similar weaknesses prevail in Russia. Based on these factors, the economies of Brazil, Mexico, and Russia are in line with the median of 'BBB' rated sovereigns, whereas China's and India's ratios exceed those of the 'BBB' median--except for GDP per capita. One factor that distinguishes Brazil is that it has a fairly closed economy compared with its peers', meaning that its level of exports of goods and services in terms of GDP remains significantly lower than that of the 'BBB' median and rated peers' (see chart 4). Brazil's economic growth strategy remains anchored on the development of its domestic market, despite the commodity boom and the overall increase in its export base. (For details about Brazil's growing trade links with Asia, see "How Important Is Trade With China To Brazils Economy?," published Nov. 4, 2010.) Greater international integration through trade has helped China and India boost their GDP growth rates, although the bulk of GDP growth still comes from their domestic markets. Only in China have net exports been contributors to economic growth in recent years. In Brazil, net exports were an important contributor to GDP growth from 2002 to 2005, while domestic demand was relatively stagnant. But an increase in investment after that led to a rise in demand for imports, reducing the impact of net exports on GDP growth. Russia's export performance is more
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related to the exploitation of natural resources, whereas Mexico's integration with the U.S. industrial sector contributes to high export levels.
Chart 3
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Chart 4
Fiscal Flexibility: High Debt And Interest Payments Put Brazil In A Weaker Position Relative To Most Of Its Peers
We frequently argue that Brazil's fiscal indicators remain the key weakness of the sovereign's credit quality in comparison with its peers. Brazil's net general government debt is the second highest among the BRIC countries--India's is the highest. Despite Brazil's commitment to fiscal prudence, we expect that the level of government net debt will remain stable or decline only gradually in terms of GDP over the next two to three years. In Mexico, China, and Russia (a net creditor), government debt is lower (see chart 5). Therefore, fiscal performance is not as important of a factor in our credit quality analyses of these governments.
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Chart 5
Brazil's fiscal pressures are even clearer when looking at general government interest payments in relation to the revenue base (see chart 6). Interest payments have been declining, but they're still higher than those of the other BRIC countries, except for India. The high interest payments relative to revenues result from an issue that characterizes Brazil's economy: Economic authorities have to balance an expansionary fiscal policy with a more conservative monetary policy, which keeps domestic interest rates high and, therefore, significantly increases government interest payments on debt. Of Brazil's general government debt, about 90% is domestic and, of that, about 34% was issued at variable interest rates.
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Chart 6
Along with this, Brazil's high tax burden somewhat limits its fiscal flexibility (see chart 7). Brazil's tax burden has been increasing over the past two decades, but additional increases, if needed, will be difficult to achieve. Of the BRIC countries, only Russia maintains a comparable tax burden.
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Chart 7
Brazil has made efforts to contain the fiscal risks by maintaining a primary surplus that is significantly higher than those of its peers (see chart 8). This relatively strong commitment to fiscal sustainability enabled Brazil to maintain manageable overall fiscal deficits of 2% to 3% of GDP (see chart 9), which is close to the 'BBB' median. (India's estimated fiscal deficit of about 8% of GDP for 2010 significantly exceeds the 'BBB' median.)
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Chart 8
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Chart 9
India suffers from more fiscal rigidity than the other BRIC countries because of its high deficits and debt. However, the government has been able to issue debt--with both long maturities and at fixed rates--in local currency in the domestic market thanks to a relatively well-developed financial system that has sufficient liquidity to absorb the government's borrowing needs while still providing funding to the private sector. However, relying on the domestic market to fund fiscal deficits could crowd out other borrowers. But doing this has insulated the sovereign from external vulnerabilities, such as the sudden loss of access to funding from external markets that occurred in late 2008. The reliance on local funding also reduces the risk of a sudden loss of liquidity or a sharp rise in the general government debt burden resulting from exchange rate fluctuations. Brazil has also made significant progress in the development of the local market as a stable source of financing for both the government and the private sector, although the government debt in the local market remains somewhat vulnerable to interest rate volatility given that one-third of the debt was issued with variable interest rates and at relatively shorter terms. The same occurs with private-sector issuances in Brazil's local market, with the additional and important influence the public sector plays in the domestic capital market by crowding out the private sector. China has much better fiscal flexibility, but it has a legacy of using the banking system for quasi-fiscal policies, which leads to large nonperforming loans (NPLs). However, because of the rapid rate of GDP growth (averaging 10% since 1980), the government has been able to generate ample resources to compensate the banks for their NPLs, helping them to recapitalize through various policies. Although the low level of general government debt gives the Chinese government flexibility to provide aid to the banking system, the financial system remains vulnerable to
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quasi-fiscal activities undertaken at the behest of the government. In Brazil--which has a relatively weaker fiscal position--the rapid expansion of credit supported by government-owned banks also raises the medium-term fiscal risk implications of these types of activities.
Monetary Flexibility: Strengthening In Brazil

Brazil's strong commitment to maintaining low fiscal deficits was key to our upgrades of the sovereign over the past several years. However, converging to a low inflation environment is a major structural improvement in Brazil's macroeconomic framework. Inflation levels in Brazil are below the 'BBB' median and those of key rated peers' (see chart 10). Brazil achieved this by allowing the central bank to operate more independently. Probably more important than declining inflation is that price increases market participants expect over the next 24 months remain within the inflation target range the central bank sets. This helps to extend the time horizon during which investment decisions are made in Brazil.
Chart 10
A cost of decreasing the inflation rate is the high domestic interest rate prevailing in Brazil. In addition to the implications that a high domestic interest rate has on the government's domestic debt, it can also lead to other problems, such as the prevalence of a segmented credit market. Subsidized loans--which the Brazilian Development Bank (or Banco Nacional de Desenvolvimento Economico e Social) sponsors--currently play a large role in the credit markets, which could pose some risks to Brazil's fiscal performance in the medium term.
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Although interest rates in Brazil remain high, they are declining, which is already yielding a substantial increase in domestic credit (see chart 11). Although rapid growth of lending could weaken the credit quality of the loan portfolio, the increasing level of financial intermediation will continue to improve the administration of monetary policy in Brazil, providing greater levels of monetary flexibility.
Chart 11
External Indicators: A Common Strength Among The BRIC Countries

External factors are one area where we find some similarities among the BRIC countries. Net liabilities and external flow of funds are credit strengths to these governments (see charts 12 to 14). In the case of China, the continuation of high current account surpluses has led to external net assets that are equal to 170% of current account receipts. One positive factor in Brazil is the country's increasing reliance on foreign direct investment (FDI) to finance the current account balance (see chart 15). In previous decades, Brazil financed its external deficits mostly by increasing debt. This is particularly important now because Brazil's current account has moved from positive to negative territory (see chart 13). FDI inflows to Brazil were equivalent to about 2.5% of GDP over the past five years.
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Chart 12
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Chart 13
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Chart 14
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Chart 15
Brazil's Stronger Political System Helps To Offset Fiscal Weaknesses

Overall, we see few similarities between Brazil and the rest of the BRICs. The countries have very different economic structures, levels of wealth, and GDP performances. Fiscal rigidities and vulnerabilities are important credit weaknesses for Brazil and, to a greater extent, for India, but the fiscal analysis constitutes a significant credit strength for China and Russia. Only the external sector presents a similar picture, with all of the BRIC countries showing important credit strengths. We believe that these differences will continue to support greater interaction among the BRIC economies going forward, in particular between Brazil and China (see "How Important Is Trade With China To Brazils Economy?," published Nov. 4, 2010). The differences among the BRIC countries are significant when focusing on the quantitative factors, and the contrast becomes even starker when looking at qualitative factors. In our opinion, the qualitative factors in our analysis of Brazil (see "Federative Republic of Brazil," published Aug. 4, 2010) provide greater support for the sovereign's creditworthiness. A well-developed and stable democratic system--which the transfer of power between administrations with differing political backgrounds has already tested--remains the most critical factor supporting the rating and differentiating Brazil from the other BRIC countries. However, the strength of Brazil's political system does not always lead to fast improvements in the economy and, subsequently, higher growth rates. But, they significantly reduce the downside risks to the sovereign's creditworthiness.
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November 4, 2010

Economic Structures: Differ Significantly Across The BRICs

Monetary Flexibility: Strengthening In Brazil

External Indicators: A Common Strength Among The BRIC Countries

Brazil's Stronger Political System Helps To Offset Fiscal Weaknesses

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