Fitch: Brazil's Recession Shows Next Administration's Challenges

The contraction in the Brazilian economy in the second quarter highlights the underlying challenges that the country's next government will face after October's presidential election, Fitch Ratings says. Medium-term economic prospects will depend greatly on measures taken by the next administration to restore confidence, reduce the cost of doing business and facilitate a faster transition toward investment-led growth.

Brazil's economy contracted by 0.6% in 2Q14 from the previous quarter, IBGE said on Friday. The fall in investment (5.3% quarter over quarter) was the main driver of the economic contraction during the quarter. At the same time, the 1Q14 qoq reading was adjusted to negative 0.2%. The economy grew by a mere 0.5% during 1H14 compared to the same period of last year. The second-quarter reading and the first-quarter revision mean Brazil is in a technical recession and that the slowdown in 2014 will be more pronounced than we anticipated in our full-year real GDP growth forecast of 1.5% (down from 2.5% last year). We will therefore lower our 2014 growth forecast in the next update of our quarterly "Global Economic Outlook," to be published in September.

Brazil is experiencing an extended slowdown. Average growth in 2011-2013 was 2.1%, less than half the 4.5% average in 2006-2010. The lagged impact of monetary tightening, and potential fiscal tightening next year, mean any recovery during our ratings forecast period is likely to be gradual. The sharp decline in confidence indicators in recent months, which may reflect perceived erosion of policy making, pre-election uncertainty and lagging competitiveness, also point to a slow turnaround.

Room for near-term demand stimulus is constrained by elevated inflation and government debt. Annual IPCA inflation continues to hover close to the upper limit of the tolerance interval around the Central Bank of Brazil's inflation target of 4.5%. Meanwhile, our baseline projections see gross general government debt stabilizing slightly below 60% of GDP (which is above the 'BBB' median). These assume some fiscal adjustment takes place next year and that growth picks up.

The main risk to the debt trajectory would be further drops in primary surpluses and sustained growth underperformance. Weak GDP growth is already affecting public finances through weaker revenue growth. The rolling 12-month public sector primary surplus fell to 1.2% of GDP in July, highlighting the growing challenges for meeting the 1.9% of GDP target for this year. Reliance on non-recurrent revenues will continue this year, which reduces the predictability of public finances.

Falling confidence indicators suggest that economic agents want to see additional policy adjustments in addition to those already undertaken, which include monetary tightening, some exchange rate flexibility and attempts to boost private investment in infrastructure. Restoring confidence, strengthening fiscal and economic policy credibility and reducing structural constraints in areas such as infrastructure and the business environment would be supportive for Brazil's sovereign credit profile if they result in faster sustainable growth. The authorities' capacity to adjust policy to address economic and fiscal imbalances will therefore remain a key focus of our sovereign ratings assessment.

We affirmed Brazil's 'BBB'/Stable rating on July 10, noting that economic diversity, relatively well-developed institutions, robust external liquidity and an adequately-capitalized banking system counterbalance ratings weaknesses as such structural weaknesses in the public finances, growth-underperformance, and limited progress in improving competitiveness and fiscal flexibility.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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