Brazil’s rating downgrade caught the government off-guard

Brazil’s rating downgrade finances

S&P downgraded Brazil’s rating to BB-. Photo: Lula Marques/PT

Early on Thursday afternoon, Finance Minister Henrique Meirelles used Twitter to celebrate an article by The Financial Times. The piece highlighted how Brazil’s auto exports had risen by 46 percent in 2017. “Brazil is exporting more cars, with better prices and better quality,” says the FT article. Minutes later, however, Meirelles got the news that ratings agency S&P had downgraded Brazil further into junk territory.

S&P cut Brazil’s credit rating from BB to BB- over the government’s struggles to approve an overhaul of the country’s costly pension system. The downgrade reflects how markets have grown skeptical of the government’s ability to pass its business-friendly (but unpopular) agenda. As the country holds its general elections in October, many congressmen might prefer to avoid approving pieces of legislation that could cost them votes.

S&P analyst Lisa Schineller released a statement justifying the decision. “Despite various policy advances by the Temer administration, Brazil has made slower-than-expected progress in putting in place meaningful legislation to correct structural fiscal slippage and rising debt levels on a timely basis.” The agency also changed Brazil’s outlook from negative to stable.

Told you so

After the announcement, Finance Minister Henrique Meirelles sort of “celebrated” the decision. “It backs what [the government] has been saying for the past months. That’s the positive part. The negative was the downgrade.” While the failure around the pension reform was certainly part of the equation, the government’s discussions around changing fiscal rules and allowing a greater federal indebtedness did not do Brazil any favors.

Despite warnings from ratings agency about a possible downgrade, the announcement still blindsided the government. The Ministry of Finance expected that, with better financial results for 2017 (which will be announced by the end of the month) Brazil would be warranted a longer leash. The past 11 days, over which the São Paulo stock market broke record after record, solidified that perception.

Despite the Finance Minister putting the blame on Congress for the shortcomings regarding the pension system reform, Speaker Rodrigo Maia defended the Legislative branch. Maia has declared that the reform wasn’t approved due to the necessity of voting (and rejecting) two indictment requests against President Michel Temer. “Indeed, the government lost strength after that,” he said. “But now is not the time to point fingers.”

The real problem is not (only) Brazil’s rating

The downgrade essentially means that Brazil represents a greater risk to creditors. The immediate consequence is a rise in interest rates for loans to the Brazilian government. But the new rating doesn’t change much how the markets see Brazil. And, at least for now, Brazil has benefitted from an abundance of capitals in the world – even for us.

What scares investors regarding the Brazilian economy is the depletion of state finances. Eighteen years after the creation of the Fiscal Responsibility Law (LRF), most states still struggle to balance their budgets.

The LRF establishes limits for public spending, and had the goal to prevent public administrators from ruining the budget before the end of their terms. The law, for instance, forbids governors from spending the majority of the budget on wages and personnel. Disrespecting that law could lead to the impeachment of the sitting governor.

States are placed under alert if they spend over 44.1 percent of the state’s finances in wages. The next alert level is called “prudential limit” and is activated after wages chew up 46.55 percent of the budget. Finally, the “maximum limit” is set at 49 percent.

The silver lining is that the number of states under alert has decreased since 2015, when all states were in that situation. Now, “only” 16 out of 27 are.

To recover states’ finances, most governors opt for the easy way out: budget cuts, privatizations, and tax raises. A consequence of this lack of fiscal responsibility is pretty evident: the security crisis that has dominated multiple states. Without money to invest in counterintelligence to fight drug cartels, Brazil’s law enforcement forces are always reactive, acting on the effect rather than remedying the cause of the violence crisis.

In Rio Grande do Norte, the state didn’t pay police officers’ November salaries until they staged an illegal strike for almost a month. Last Saturday, the local government declared a state of “public calamity.” On December 29, the federal government sent a total of 2,800 troops to perform police duties. It was the third time the Armed Forces have been sent to the state since August 2016. Without the police, rates of violence spiked, with an average of 7 murders every day.

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