Brazil Faces Both Old And New Challenges On The Path To Sustainable Economic Growth

Primary Credit Analyst: Sebastian Briozzo, Buenos Aires (54) 114-891-2120; sebastian.briozzo@standardandpoors.com Secondary Contacts: Joydeep Mukherji, New York (1) 212-438-7351; joydeep.mukherji@standardandpoors.com Delfina Cavanagh, Buenos Aires (54) 114-891-2153; delfina.cavanagh@standardandpoors.com Jose M Perez-Gorozpe, Mexico City (52) 55-5081-4442; jose.perez-gorozpe@standardandpoors.com Edgard Dias, Sao Paulo +55 (11) 30399771; edgard.dias@standardandpoors.com

Table Of Contents
The Same Old Problems And There Are New Challenges As Well Local And Regional Governments Are Borrowing Again The Banking Industry Has Its Own Challenges OGX And The Prospects Of The Hydrocarbon Industry Overcoming Roadblocks Related Criteria And Research

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Brazil Faces Both Old And New Challenges On The Path To Sustainable Economic Growth
(Editor's Note: In the context of the negative outlook revision on Brazil in June, Standard & Poor's has published a series of commentaries that, from different perspectives and across sectors, assess the sustainability and risks of some critical developments occurring in the country.) Not too long ago, Brazil was considered a key emerging market with strong growth potential. Brazil's sovereign bonds were trading at rates comparable with those Standard & Poor's Ratings Services rated 'A' even though the historical sovereign rating on Brazil was 'BBB' or lower. Its growth prospects used to be compared with those of fast-growing economies such as India and China. Now, however, the Federative Republic of Brazil (foreign currency rating: BBB/Negative/A-2) is likely to suffer its third year of modest economic growth. And we do not expect growth prospects to change much over the next three years. Standard & Poor's expects GDP will expand only 2.0% in 2013, after increasing 2.7% in 2011 and 0.9% in 2012. The weak growth reflects modest export performance and declining private-sector investment, partly because of ambiguous policy signals from the government that have dampened investor confidence. Household spending could also slow further amid higher consumer indebtedness. Modest growth has contributed to a marginal weakening of the sovereign's financial profile, including deteriorating fiscal performance and a rise in the government's debt burden. Are these challenges what any country would face while transitioning toward increased economic development, or is Brazil still struggling with unresolved structural obstacles that continue to limit its growth potential? Not surprisingly, the answer is a little bit of both. Brazil has progressed markedly in the critical task of reducing macroeconomic vulnerabilities that led to a series of economic, fiscal, and financial crises over the past three decades. But several challenges remain--both old and new. Overview Standard & Poor's expects GDP growth to average a modest 2.6% over the next three years in Brazil. Brazil will have to boost private and public sector investment to reach higher growth rates without compromising macroeconomic stability. Already high household indebtedness, in a context of increasing interest rates, will present new challenges to the health of Brazil's banking system, as well as to government policies to boost mortgage lending.

The Same Old Problems

Brazil's difficulty to reach high levels of sustainable economic growth is not a new problem. In fact, Standard & Poor's 2.6% annual average GDP growth estimate for the next three years is just slightly below Brazil's average growth rate during 1999-2012 (3.2%) (see table). The difficulties to reform a public sector that remains more of an obstacle than an instrument for a dynamic economy have been present in Brazil for many decades now. Brazil's public sector has

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reduced its reliance on external debt and cut its interest costs significantly over the past 14 years. Nevertheless, net general government debt remains high (see table). For decades, Brazil's leadership has not been able to comprehensively reform the pension system or the tax structure, both of which severely limit public sector flexibility, restricting public investment and overall economic growth. Brazil has one of the highest tax burdens within emerging markets, little spending flexibility, large domestic refinancing needs, and low levels of public investment. Brazil--Main Economic Indicators
Average 1999-2002 Foreign currency rating range Rating category GDP per capita (US$) Real GDP (% change) Real GDP per capita (% change) Gross domestic investment (% of GDP) General government balance (% of GDP) Net general government debt (% of GDP) General government interest expenditure (% of revenues) Consumer price index (% change) Current account balance (% of GDP) Net foreign direct investment (% of GDP) Gross external financing needs* (% of CARS and usable reserves) Narrow net external debt* (% of CARS) B+/BBSpeculative grade 3,317.4 2.1 0.6 16.5 (7.2) 52.5 29.1 6.8 (3.5) 4.2 156.1 256.7 4,918.6 4.0 2.7 16.2 (3.7) 47.7 19.7 7.3 1.1 1.2 101.4 81.0 Average 2003-2007 B+/BB+ Average 2008-2012 BBB-/BBB Investment grade 10,488.2 3.2 2.2 18.8 (2.7) 44.2 13.6 5.6 (2.0) 2.2 73.0 8.9 Average 2013e-2016f BBB/Ongoing Investment grade/ongoing 11,698.4 2.6 1.8 19.4 (3.2) 46.7 11.5 5.7 (3.4) 2.4 67.8 21.2

Gross external financing needs are defined as current account payments plus short-term external debt at the end of the prior year plus nonresident deposits at the end of the prior year plus long-term external debt maturing within one year. Narrow net external debt is defined as the stock of foreign and local currency public and private sector borrowings from nonresidents minus official reserves minus public-sector liquid assets held by nonresidents minus financial sector loans to, deposits with, or investments in nonresident entities. A negative number indicates net external lending. CAR--Current account receipts. e--Estimate. f--Forecast. The data and ratios above result from Standard & Poors own calculations, drawing on national as well as international sources, reflecting Standard & Poors independent view on the timeliness, coverage, accuracy, credibility and usability of available information. Source: Standard & Poor's.

And There Are New Challenges As Well

The successful transition of about 35 million people to the middle class--probably the greatest success of the past decade in Brazil--is reshaping Brazil's political economy framework. This new middle-class population is adding pressure with demands that include low inflation, better public services, infrastructure, banking services, and housing. And as the massive public demonstrations in June showed, the government isn't delivering according to expectations. To a large extent, this new middle class is dealing with Brazil's old infrastructure--one meant for a different type of social structure. Reforming the public sector over the coming years to give it more flexibility and to better meet the changing demands of society is key to unleashing the higher investment and growth that Brazil would need to sustain its economic development.

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Brazil Faces Both Old And New Challenges On The Path To Sustainable Economic Growth

The key impediments to boosting private and public sector investment in these areas lie at the core of the key problems Brazil will have to solve over the next five to 10 years to continue its process of sustained economic development. However, the critical aspect of dealing with these old and new challenges is to find solutions that are consistent with a sustainable path over the medium and long term. This is when the rating analysis, not only at the sovereign but also at the local and regional governments, banks, and corporates, remains critical. As in the recent past, a long-term sustainable approach is one that maintains economic stability, limiting inconsistent policies and boosting both private and public sector investments. Given Brazil's already limited fiscal flexibility, a strategy that relies on fiscal policies (including quasifiscal policy based on lending by government-owned banks) to play a more ambitious counter-cyclical role in boosting economic activity could cause government debt to increase such that it becomes inconsistent with our current rating. The authorities' main strategy seems to recognize these restrictions and, therefore, aims to promote a greater development of private sector investment. However, gross domestic investment (which is mostly private sector) has increased only modestly compared with the period we rated Brazil speculative grade (rated 'BB+' or below) (see table). The government's ambiguous and erratic approach toward the private sector in recent years has failed to boost private investment. In addition, the increasing pressures from social protests and their impact on the relationship between the executive branch and Congress--amid the declining popularity of President Dilma Rousseff and upcoming general elections in 2014--will test the government's commitment to cautious fiscal policies. (For a detailed explanation of the different scenarios for our sovereign rating on Brazil, please see "Supplementary Analysis: Federative Republic of Brazil," published July 19, 2013.)

Local And Regional Governments Are Borrowing Again

The recent deterioration in fiscal dynamics has hurt more than just Brazil's central government. Less dynamic revenues and pressure to increase capital expenditure have also reached local and regional governments (LRGs). High debt service costs, cumbersome bureaucracy or delays in the execution of public works, and stringent restrictions on borrowing under the 2000 Fiscal Responsibility Law are among the structural impediments limiting capital expenses, but they are keeping the LRGs' fiscal deficits under control. Larger states in Brazil will need to address the ambitious goal of increasing investment while continuing to comply with the Fiscal Responsibility Law. In our view, a more flexible approach to financing that would gradually allow states to assume new debt could present a solution but could also imply additional risks. (See "Does The Outlook Revision On Brazil To Negative Affect Its Local And Regional Governments?," July 23, 2013.)

The Banking Industry Has Its Own Challenges

Our Banking Industry Country Risk Assessment on Brazil presents a comprehensive analysis on a sector critical for Brazil's ability to support higher sustainable growth rates but that could also pose risks to medium term stability. While higher levels of financial intermediation in Brazil may be positive, economic imbalances have worsened as a result of

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rapid credit expansion that further raised the household debt burden. Brazil's only moderate leverage in the corporate sector and the absence of high-risk loans in banks somewhat mitigate these higher risks. However, we assess the economic risk trend for Brazil's banking sector as negative. Despite slower credit growth during 2012 and 2013, we believe that a new period of rapid credit expansion could result from the current Administration's policies. Further lending could increase an already hefty household debt burden, subjecting the financial system to incremental credit risk. The industry risks in Brazil's banking sector have increased because of growing market distortions from a rising market share of loans from government-owned banks and a widening spread differential in lending interest rates between public and private banks. Extensive coverage, effective supervision of the financial system, and an adequate and stable deposit base support our industry risk assessment. (See "Banking Industry Country Risk Assessment: Brazil," July 22, 2013.)

OGX And The Prospects Of The Hydrocarbon Industry

After the discoveries of oil in the pre-salt layers of rock beneath the ocean off the coast of Rio de Janeiro, Brazil's hydrocarbon industry should become a key source of growth for Brazil. The country's external accounts will likely improve considerably because it will export most of the oil. Higher oil production could also finance the development of other economic sectors in Brazil. However, the EBX Group--a conglomerate of oil and gas, mining, energy, shipbuilding, and logistics companies--has recently failed to meet output targets and delayed ramping up its projects. Of the group's five listed companies, the only one we rate, OGX Petroleo e Gas Participacoes S.A. (OGX; CCC/Negative/--), has been posting sharply lower-than-expected operating performance and has frequently revised downward, sometimes very abruptly, its production plans. This has raised questions not only on the overall prospects of the oil and gas industry in Brazil but also on the potential impact this group could have on the health of the banking system. In our view, OGX's disappointing exploration and production results won't harm Brazil's overall oil and gas industry prospects because of large reserves and the potential for Petrobras' (Brazil's largest oil company) to almost double its production in the next 10 years. In addition, EBX's debt represents less than 1% of the Brazilian financial system's total outstanding credit, therefore limiting the potential systemic implications. (See "What Are The Implications Of The EBX Groups Restructuring For Brazilian Banks?,"July 16, 2013.)

Overcoming Roadblocks
Macroeconomic risks aren't the only vulnerabilities Brazil must handle for its economy to continue growing. Reforming the public sector is key for growth, as is the success of LRGs, banks, and corporations. If Brazil maintains economic stability and limits inconsistent policies while increasing both private and public sector investments, growth could surge. But Brazil's struggles aren't new, and it has a long way to go to overcome them.

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Related Criteria And Research

Does The Outlook Revision On Brazil To Negative Affect Its Local And Regional Governments?, July 23, 2013 Banking Industry Country Risk Assessment: Brazil, July 22, 2013 Supplementary Analysis: Federative Republic of Brazil, July 19, 2013 What Are The Implications Of The EBX Groups Restructuring For Brazilian Banks?, July 16, 2013 Brazil Outlook Revised To Negative; 'BBB/A-2' Foreign Currency Ratings Affirmed, June 6, 2013

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