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Brazil: Worst Recession Since 90s

We expect Brazil's economy to shrink by 1 percent this year, while inflation and interest rates should remain elevated. Despite fiscal slippage, the probability of a debt crisis is still low, but risks need to be monitored.

Brazil's economic outlook for 2015 is characterized by a number of negatives, including rising inflation, weakening growth prospects, the risk of power shortages due to a lack of rainfall (weighing on electricity generation at hydropower plants), and the Petrobras-related corruption scandal. In addition, the prospects of Fed tightening and further currency depreciation could increase financial stress. We now expect a contraction in GDP of 1 percent YoY in 2015 (the worst result since 1990) after stagnation in 2014. We also see downside risks to our scenario of a modest recovery in 2016. At close to 7.5 percent, inflation is likely to remain high for most of the year, and the policy rate may temporarily be raised above 13 percent.

Recession and Political Risks Could Prolong Fiscal Adjustment Process

We think that fiscal tightening – about 2 percent of GDP in spending cuts and tax hikes have been announced so far – and prudent monetary policy should help rein in inflation and bring interest rates down over the medium term. However, we also think that additional policy tightening will be necessary, and we see substantial risks of fiscal slippage given the weak economy. Moreover, the declining popularity of the current government (as reflected in recent mass protests and low approval ratings in opinion polls) could lead to increasing uncertainty regarding progress on reforms. As the economy weakens, public resentment will likely be exacerbated. Worsening political gridlock would likely slow reforms. The medium-term economic and fiscal outlook could then worsen and cause further downgrades of Brazilian sovereign debt by major rating agencies.

Probability of Sovereign Debt Crisis Low at This Point

Despite some fiscal slippage, the probability of a debt crisis seems low at this point. Government debt levels are expected to rise, but remain close to their long-term average (around 65 percent of GDP). Also, the recent depreciation of the Brazilian real should have a limited (direct) impact on the sustainability of government debt given that public external debt is relatively low at 6 percent of GDP. That said, there are still substantial fiscal risks if the government had to financially support companies that ran into trouble.

Risks From Petrobras and Public Banks Need Monitoring

Although this is not our base case, Petrobras could fail to deliver a qualified financial statement at the end of May. Creditors might then accelerate payment claims. If the government decided to bail out the company, a downgrade of sovereign debt to below investment grade would almost be guaranteed (outstanding Petrobras bonds and loans equal 5 percent of GDP). Meanwhile, the mix of a deteriorating economy, rising external and domestic funding costs as well the strong increase in private debt (+24 percent of GDP since 2010) poses a risk to banks. At this point, we do not see any systemic risks given that non-performing loans are still at low levels (they have actually come down during the past two years). Capital buffers remain quite high, particularly among the largest private banks in Brazil. However, public banks need to be monitored more closely, as they have so far relied on subsidized loan provisions funded by the government (whose support is likely to weaken). Also, these banks appear to have a relatively larger exposure to the troubled energy and construction sectors.