Standard & Poor (S&P) recently downgraded Brazil’s credit rating to non-investment grade and maintained a negative outlook, signaling that further cuts are possible. Once a darling of emerging markets, Brazil is now facing a painful and possibly prolonged recession, and is caught between policy inaction and political turmoil – both of which threaten to delay the recovery even further.
From rising star to fallen angel
Throughout the 1980s, during the so-called “lost decade”, Brazil was plagued by hyperinflation, external imbalances and a worsening fiscal position. By the early 1990s the economic situation became untenable, political instability took over and culminated with the impeachment of the president in 1993. The following administration implemented a stabilization plan and successfully carried out structural reforms that regained economic stability and began to rebuild international credibility.
A decade later, Brazil was a rising star as it rode the wave of the commodity boom of the 2000s, which provided strong tailwinds to the economy and growth opportunities abounded. In addition, economic policy was conservative, based on three pillars: fiscal responsibility, inflation targeting and a floating exchange rate. S&P awarded Brazil investment-grade status in April 2008.
To offset the impact of the 2008-2009 crisis, the government took on a greater role in economic management, seeking to boost domestic demand through sizable credit expansion, transfers, subsidies and price caps. As a result of this massive stimulus, GDP growth in 2010 was a record 7.5%, only trailing China and India. This period marked a critical shift in economic policy, as the government gradually abandoned fiscal responsibility for aggressive expansionary policies. While commodity prices were high, this was not a big concern but by 2010 the commodity super cycle was coming to an end.
Despite the headwinds the fiscal stimulus continued until late 2014. Brazil’s government came under severe pressure from market participants including rating agencies, to carry out a meaningful fiscal adjustment and restore the central government budget surplus. In response, the (left-leaning) government appointed a “market friendly” finance minister to implement a credible plan to return to prudent fiscal management. To add to the mix, a far-reaching corruption probe into Petrobras, the state-owned oil giant, has adversely impacted already weak growth dynamics and severely polarized the political environment – further thwarting any fiscal adjustment efforts. Brazil's macro and political environment deteriorated considerably throughout 2015, but it was the lack of political will to implement the necessary fiscal tightening that prompted S&P to downgrade Brazil to sub-investment grade.
Will the S&P downgrade serve as a wake-up call for lawmakers and politicians to stand behind the government’s fiscal adjustment plans, as was the case in India in 2013? The complexities of Brazil’s economic and political realities are so daunting, that it is difficult to believe that we’ve reached the inflection point. The crisis of the 1980s is a reminder that the confluence of economic and political turmoil can turn into a multi-year quagmire.
However, as dire as Brazil’s situation is, it is important to point out that we are still far from a solvency crisis like the ones faced by emerging markets in the 1980s and 1990s. Since the mid-1990s, Brazil – like many other EM countries – has paid down (foreign) debt, accumulated massive foreign reserves, dramatically reduced its dependence on foreign funding, and strengthened its monetary policy framework. These adjustments might just be enough to avoid an outright financial crisis, but essential and painful adjustments are still needed. These will take time, weighing on an economy that is already facing the headwinds of the end of the commodity super cycle. How Brazil manages these difficult times is not only important to the country itself, but given its size and prominence, the outcome is also crucial for the rest of Latin America and the broader emerging market world.