Fitch Lwrs Brazil's Foreign Currency Sovereign Rtg To 'B+'; Outlook Negative.

Business Editors

NEW YORK & LONDON--(BUSINESS WIRE)--June 20, 2002

Fitch Ratings today lowered Brazil's foreign currency sovereign rating to 'B+' from 'BB-' and kept the local currency (Brazilian real) rating at 'B+'. The Rating Outlook remains Negative.

Since February 2002, when Brazil's ratings and Negative Outlook were affirmed, financial market conditions facing Latin America's second largest economy have deteriorated. Given the vulnerability of Brazil's public debt burden and balance of payments to investor sentiment and little likelihood that this sentiment will improve markedly in the coming months, Brazil's sovereign credit fundamentals have taken a turn for the worse. A shortening of domestic debt maturities, a sharp rise at the long end of the domestic yield curve, pressure on foreign exchange reserves, and, at least temporarily, a closure of access of the sovereign to the international capital markets all suggest a higher risk of deteriorating public debt dynamics and balance of payments pressures. This comes in spite of a robust policy response, including an increase in the public sector primary budget surplus to 3.75% of GDP and actions to curtail liquidity in the foreign exchange market. Furthermore, the Brazilian authorities obtained additional support from the multilateral financial institutions, including the IMF.

Of domestic securities maturing over the next five years, which represented 45.9% of GDP in June 2002, the proportion maturing over the next year rose to 39.4% from 31.2% as a result of recent operations to meet market demand for shorter maturities. The spread on the overnight Selic interest rate and the one-year rate widened to more than 1000 basis points from around zero earlier in the year. Brazil's country risk spread, i.e. the spread between Brazil's sovereign external bonds and comparable U.S. treasuries, widened to more than 1500 basis points in late June from 750 basis points earlier in the year. The inability to access international capital markets, in conjunction with heavy external financing needs that could total US$48 billion this year (including the current account deficit and medium and long-term external debt amortizations), has put additional pressure on Brazil's already low foreign exchange reserves. Likewise, short-term external debt, representing approximately US$30 billion, is at risk of not being rolled over at maturity. On the other hand, balance of payments pressures from the heavy private external financing demands may be partially mitigated by the fact that much of the short-term debt is trade-related and private companies have been accessing credit via such vehicles as export receivables transactions.

The implications for Brazil's public debt dynamics of the recent market action are negative. The Brazilian government has debt representing about 34% of GDP that is denominated in or indexed to the exchange rate, which has depreciated 14.5% since year-end, increasing the government debt burden. Likewise, expected interest rate declines driven by slack demand conditions may have been postponed in order to forestall the inflationary effects of the recent depreciation and to compensate investors for heightened country risk. This will both hinder Brazil's ability to grow out of its heavy debt burden (general government debt represented 69.5% of GDP at year-end 2001) and pressure public finances by keeping the interest bill high (general government interest expense represented 8.2% of GDP last year). Fitch Ratings points out, however, that a virtuous debt dynamics scenario remains possible, underpinned by a strengthening currency and easing interest rates, but that it appears that current market conditions could persist in the near term.

In response to the deterioration in market conditions, the Brazilian authorities announced an increase in the public sector primary surplus target for 2002 to 3.75% of GDP from 3.5%, and raised indicative federal government surplus targets in its multi-year budget plan (LDO) to 2.8% of GDP. Fitch Ratings has suggested in the past that higher public sector primary surplus targets over the medium term, i.e. greater than 4% of GDP, would be warranted to enhance prospects for debt sustainability. In recent years, the Brazilian authorities have been able to consistently exceed their primary surplus targets (i.e. a 3.75% of GDP surplus was obtained in 2001, versus a target of 3.35%).

Brazil's balance of payments vulnerability has increased as a result of the recent deterioration in sentiment. The central bank has had to intervene in the spot market and use foreign exchange repos to signal its support of a stronger Real. Furthermore, external borrowing and portfolio inflows have been severely constrained, given current market conditions, though FDI has remained robust through May 2002. In this environment, the Brazilian authorities once again turned to the multilaterals for financing, drawing on US$10 billion from its IMF stand-by facility and US$1 billion from the World Bank. As a result, international reserves were about US$40 billion in late June, though only US$29.8 billion consisted of net international reserves (NIR, net of IMF borrowings). The IMF agreed to allow Brazil to lower the its NIR floor to US$15 billion, freeing almost US$15 billion in reserves to intervene, buy back sovereign debt, or otherwise support the balance of payments. Nevertheless, with US$7.9 billion in public external debt service due during 2H02, as well as US$12.8 billion in public external amortizations (excluding interest payments) due in 2003, if access to the international capital markets is restricted for too long, the authorities may require additional multilateral funds.

On the political front, national elections are due to take place in October 2002, to choose not only a successor to President Fernando Henrique Cardoso, but also much of the Congress and state and local governments. Whichever candidates and parties prevail in the elections, the incoming governments will be challenged to navigate Brazil's fractious political system in order to maintain or even tighten the current macroeconomic policy settings and to put economic reforms back on track. Fitch Ratings will closely monitor market conditions and economic performance, as well as the risks to the economic policy framework emanating from the elections up to and in the wake of the October elections.