Brazil’s just been downgraded to junk by Standard & Poor’s. What does it really change?
Everybody knew the storm was coming, and yet many people got caught in the rain. Having sent warning signals that it was considering Brazil for a downgrade, Standard & Poor’s enacted on its threat sooner than expected by cutting Brasilia’s rating to junk on Wednesday. It also put the country on negative watch, in a double whammy of bad news few had anticipated.
Moody’s and Fitch, meanwhile, kept their ratings unchanged. And there are signs that the latter at least has no immediate intention to strip Brazil of its investment grade. Given that the votes of two out of the three agencies are conventionally needed to push a country into junk territory, does S&P’s decision really matter?
Not very much, the markets seem to think. While the real, Brazil’s currency, initially slid 3 percent against the dollar to a 13-year low yesterday, it then pared back losses to close down 1.3 percent. Stock traders stayed even more sanguine: the benchmark Bovespa index only fell 0.33 percent on the day.
That led some to say that the downgrade was already priced in, and others to argue that S&P’s double shock was overdone. Société Générale was on the latter side. At 32 percent of GDP, the bank reckons Brazil’s external debt stands among the lowest across emerging markets. The real’s depreciation will cause the ratio to deteriorate, but Société Générale predicts it will reach about 40 percent by year end, still a moderate level by global standards.
More importantly, the lender points out, only 8 percent of the country’s foreign-denominated debt is classified as short-term. With currency reserves amounting to $366 billion – equal to around 6 times short-term debt external debt – Brazil has some breathing space before being forced to default.
Société Générale has a point. The trouble is, investors and lenders usually follow ratings no matter whether they’re on target or exaggerated. The consequences are material: it will become more expensive for Brazil to borrow, as interest rates and bond yields tend to raise even after a single agency’s downgrade. At a time when the country’s struggling to tidy up its finances, that’s not good news. It will also cause a number of investors to dump their holdings of Brazilian bonds as they anticipate a possible second downgrade. That will make Brazil’s current account deficit worse and put further pressure on the currency.
Most importantly, sovereign downgrades don’t affect just sovereigns: they also tend to depress equities and limit corporates’ ability to borrow (corporate credit ratings are constrained by that of their host country). And for Brazil, this is where the greatest potential trouble really lies: although the government has relatively little external debt, Brazilian companies have issued a lot of foreign currency bonds over the last few years. A number of large groups, including crisis-stricken Petrobras, will find it difficult to repay. Some may have to be bailed out, further constraining the government’s finances.
Perhaps people shouldn’t have been so surprised by S&P’s decision. Rating agencies have moved on from focusing solely on a government’s strict ability to repay, as this FT story argues. They’re now keener to consider the broader macroeconomic picture, including structural issues such as the business environment, corruption and economic diversification. Whether they’re right in doing so is an interesting debate. But their ability to impact emerging markets’ economic prospects is not in question.