Fitch Rates Brazil's Global Bond Due 2017 'BB'; Outlook Stable.

NEW YORK -- Fitch assigns a 'BB' rating with a Stable Outlook to Brazil's USD1.5 billion Global bond issued this week, with a maturity of ten years (2017) and a coupon of 6%. Fitch last upgraded Brazil's sovereign ratings (long-term foreign and local currency Issuer Default Ratings) to 'BB' from 'BB-' in June, reflecting the improvement in the country's external finances, especially the sharp reduction in the public sector's external exposure.

Brazil's national elections in October yielded the reelection of the center-left incumbent, President Lula, as well as a deeply divided Congress lacking clear coalitions. As a result, the prospect for pro-growth economic reform remains at best challenging. The consequent uncertainty about medium-term GDP and export growth prospects, as well as likely pressures to loosen macroeconomic policies, could slow improvement in Brazil's sovereign creditworthiness.

The centrist PMDB party gained seats in the lower house of Congress and has become the largest single party in that chamber. Not currently affiliated with either the government or the opposition, the PMDB could be the key to governing Brazil in the next four years. Yet even this party lost seats in the Senate (upper house), yielding its leadership position to the PFL, one of the principal opposition parties. The current coalition of opposition parties headed by the PSDB gained seats in the lower house, but fell some 30 seats short of the ruling PT coalition, which with 223 seats is itself short of a simple majority.

Furthermore, a new electoral rule (the 'minimum barrier clause') penalizes parties that failed to meet a minimum threshold of votes, making existing coalitions untenable. Hence, the president will not only have to lure the PMDB party into a coalition, but will have to appeal to opposition parties to obtain the votes of 60% of both chambers necessary to reform the constitution. Brazil's constitution regulates minute aspects of public policy, necessitating amendments for ordinary economic reforms. In order to maintain the current level of taxation and ensure spending flexibility, constitutional amendments extending the term of the CPMF financial transactions tax and the DRU de-earmarking provision, both of which expire in 2007, will be needed.

Fitch's upgrade of Brazil's sovereign ratings last June reflected not only improved external finances, but also the assumption that the country's sound macroeconomic policy settings would continue into the next administration. The commitment to a sizable primary budget surplus target, currently at 4.25% of GDP, to a prudent inflation-targeting monetary policy, and to a flexible exchange rate has underpinned lower inflation and a decline in real interest rates in recent years. Yet public spending growth has been very strong in this election year, with real federal spending rising 9.6% in 1H06. The Lula government will likely have to apply the brakes on spending in order to ensure meeting the primary surplus target next year. Any further unwinding of the commitment to sound macro policies in the coming years would result in a deterioration in sovereign creditworthiness. Fitch will closely monitor the Lula government's choices to fill key economic policy posts, as well as official statements about the continuity of macro policies.

Over the longer term, good macro policies are not enough. Pro-growth reforms are the only way to get Brazil's heavy government debt burden, which stands at 70-75% of GDP, on a clear downward path. The list of reforms that would improve growth prospects and public debt dynamics is well-known: central bank independence; social security reform; a more pro-business tax regime and ultimately a lower tax burden; permanent de-earmarking of revenues and broad spending control; labor reform easing restrictions on hiring and firing; microeconomic reforms and policies promoting infrastructure investment; and reforms encouraging financial sector competition. Given Brazil's heavy electoral calendar, early passage of reforms is critical to the government's success.

In addition to economic reform, sovereign creditworthiness in Brazil would be served by a political reform that strengthens political parties and reduces the current fragmentation of power, which would enhance the prospects for substantive public policy action.

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