Can Brazil Turn Its Economy Around?

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Can Brazil Turn Its Economy Around? by Knowledge@Wharton

Felipe Monteiro on Brazil’s Sovereign Rating Downgrade

Rating agency Standard & Poor’s downgrade last week of Brazil’s sovereign rating to the non-investment or “junk” category is a wake-up call for the country to correct its finances and build the political consensus to achieve that. Brazil is facing a severe recession, and its economy is expected to shrink by 3% this year and again in 2016, before returning to modest growth by 2017, according to S&P.

It does not help that an economic slowdown is also underway in China, Brazil’s main trading partner, hurting the latter’s exports to that country. Meanwhile, Brazil is wracked by corruption scandals involving senior politicians that threaten the stability of the government of President Dilma Rousseff, who is now in her second term. Despite those headwinds, experts feel Brazil still has time to correct its course, restore confidence among investors and lenders and avert another, potentially devastating downgrade.

“The junk rating is a big warning … [and] a big red flag,” said L. Felipe Monteiro, professor of strategy at INSEAD in France and a senior fellow at Wharton’s Mack Institute for Innovation Management. Monteiro is an expert on Brazil, having taught there and advised foreign companies investing in that country. “The likelihood of another downgrade depends on what Brazil does now to address the issues that have been raised.”

Monteiro discussed the implications of the downgrade for Brazil on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

Formidable Challenges

In its rating action last week, S&P cited mounting political challenges Brazil faces, “a lack of cohesion” in Rousseff’s cabinet and the possibility of “greater economic turmoil” than the rating agency currently expects. In particular, it noted repeated revisions to Brazil’s fiscal targets in a short period. Brazil’s government on August 31 proposed a budget with a primary deficit of 0.3% of its gross domestic product (GDP), instead of a 0.7% surplus it targeted in July, which also was a revision from earlier estimates. “This change reflects internal disagreement about the composition and magnitude of measures needed to redress the slippage in public finances,” S&P said in its research update last week.

Monteiro used the analogy of exercise and good health to explain Brazil’s downgrade. “Everybody knows we need to exercise and eat healthy, and sometimes you only [act] when you have a heart attack?Twitter ,” he said. “I see the current downgrade as a heart attack. Brazil now needs to eat healthy and exercise.” If the country “continues to be in denial, the consequences would be much stronger than just a heart attack” and may risk the life of the patient, he added.

Already, Brazilian companies that took on $270 billion in international debt during the boom years are seeing their funding costs rise after the downgrade, according to a Bloomberg report. However, the downgrade has not yet caused widespread panic among global investors because the two other big rating agencies, Moody’s and Fitch Ratings, maintain an investment-grade rating for the country, said Monteiro. “If more than one rating agency were to downgrade the country, it could lead to a flight of capital from the country,” he said. Alongside, if the U.S. Federal Reserve were to signal higher interest rates, that would make it more expensive for Brazilian companies to raise money, he added.

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