With the VIX index trading 10 points lower at 17.08 and a very rangy USDJPY (trading sideways at around 120), we believe there isn’t any new outstanding topic to talk about, therefore we decided that a little article on Brazil could do it ahead of this new week.
Brazil’s summary on a chart
We would like to start this review by first commenting the chart below, representing the key elements that we usually like to watch. As you can see, the SELIC (Blue/White line), Brazil’s central bank (CBB) target rate, stands now at a 9-year high of 14.25%. Since the end of 2012, CBB policymakers have started a tightening cycle and has been forced to maintain it especially over the past 12 months as the currency – Brazilian Real – is collapsing. The real (yellow line) has depreciated by 56% in one year and now trades at 3.76 against the greenback. Looking at the range over the past 9 years, it reached a low of 1.5360 in July 2011 and a high of 4.2480, which represents a 178% devaluation. This aggressive depreciation of the currency has led to inflationary pressures (CPI YoY – green line – printed at 9.5% in September) and the CDS spread 5 year rose from 126bps to 418bps (with a high of 545bps in the end of September).
Brazil’s dollar-denominated debt…
Clearly, the central bank has been constantly intervening in order to calm investors’ fear of a potential default. Based on a study from the Bank of International Settlement (Working Paper No 483), dollar borrowings in Brazil has reached more than 300 billion dollars (with giant Petrobras holding one third of the shares). Holding a dollar-denominated debt (Loans, debt securities or offshore issuance) means basically that you are short US Dollar. Therefore, if the Brazilian Real keeps depreciating against the US Dollar over the long-term, all these non-financial Brazilian companies will have difficulty in meeting their debt obligations. For instance, the chart below shows the consequence on a Brazilian Company – Petrobras – that holds almost USD100bn of US-denominated debt. Its 5-year CDS spread (White Line) more than doubled over the past 6 months from 390 to 830 bps (with a high of 1025bps in the end of September), the equity price (Yellow line) almost decreased by half of its value and the company’s perpetual 2115 bonds are now trading at 71 cents on the par.
Brazil’s fiscal situation
As we are looking at the country’s financial stability, let’s review how the government is handling its budget. Brazil has an on-balance-sheet debt-to-GDP ratio of roughly 65% (as of July 2015), which has been constantly rising over the past 5 years due to the end of the commodity super-cycle. Based on article from the The Economist, the country’s budget deficit was projected to grow to 9% of GDP in 2015, with interest payments reaching an outstanding 8% (as a share of GDP). Higher short term rates to protect the currency and higher long term rates as investors lose confidence on the country’s sustainability, this situation can only deteriorate in my opinion.
(Source: The Economist)
Its projected 2.3% contraction for this year (Brazil has now printed two quarters of negative growth QoQ, -0.7% in Q1 and -1.9% in Q2) has ‘forced’ rating agencies to downgrade its credit rating to junk status (S&P reduced it to BB+ with negative outlook last September). As you understand, the country has now entered in the so-called ‘negative spiral’, which usually leads to a long recessionary period. Economist are already projecting a zero-growth for the year 2016, and this is assuming the country’s institutions respect their debt obligations.
Political instability: Congress and Rousseff divergence
On the top of the current catastrophic situation for this used-to-be prosperous EM country, Brazil faces a political turmoil. President Dilma Rousseff currently faces many enemies in Congress (i.e. Congress blocking budget proposals) which can only worsen the country’s financial stability . For instance, her plan to reinstate a tax on financial transactions last month (38bps levy, known as CPMF) which could have raised 70bn Reals a year in revenue was eventually withdrawn as Congress would never have approved it. We saw on Wednesday that Congress postponed for a fourth time voting on whether to overrule President Rousseff’s vetoes on extra spending. The bills she vetoed would increase public spending by over 100bn real over the next four years. The central bank recorded a primary fiscal result (government budget balance before interest payments of 0.75% of GDP in August, therefore cannot afford to spend more than.
To conclude, both the political and financial situations are to follow closely over the next few months and we will see if the Fed will look at Brazil as an additional threat for the EM crisis.