Brazil Goes Investment-Grade

Strong international commodities prices are part of the reason S&P upgraded the South American country's long-term foreign currency sovereign debt

by Geri Smith

Just five years ago, it would have been impossible to envision Brazil as an investment-grade country: The South American nation was strapped with billions in debt, and many investors believed the new, leftist President would ramp up already-high government spending. But President Luiz Inácio Lula da Silva—a former firebrand labor unionist elected in 2002 and reelected for a second four-year term in 2006—has proved to be a careful steward of Latin America's largest economy. And the country has been blessed with strong international commodities prices that have transformed the onetime foreign debt defaulter into a fast-growing economy flush with foreign reserves.

That explains why, on Apr. 30, Standard & Poor's upgraded Brazil's long-term foreign currency sovereign debt to investment-grade. The long-awaited move will make it possible for a wider universe of international investors, including massive U.S. pension funds, to plunge into the Brazilian stock market. The upgrade sparked a 6.3% rise in the index of the São Paulo stock exchange, or BOVESPA, which soared to an all-time high of 67,868 points. (The exchange was closed today for the May 1 holiday.)

Positive Ripple Effects

The market is up 13.8% so far this year in dollar terms. S&P sovereign analyst Lisa Schineller said the upgrade reflects "the maturation of Brazil's institutions and policy framework, as evidenced by the easing of fiscal and external debt burdens and improved trend growth prospects." It also recognizes the government's "track record of pragmatic fiscal and debt management policies," she said.

Mike Conelius, head of emerging market bond strategy for T.Rowe Price (TROW), says the upgrade is an "affirmation of the strong fundamental improvements we've seen in Brazil" in recent years. "It reinforces the market's perception that Brazil has done and is doing the right things, and so now it's a safer place for pension funds and other investors to invest their assets—it's a seal of approval," he says.

The real bonus for Brazil, he says, will come when a second ratings agency—either Moody's Investors Service (MCO) or Fitch Ratings—also upgrades the country, something Cornelius expects this year. That's because large U.S. fixed-income investors, including pension funds and other institutional investors with some $2.6 trillion in play, use the Lehman Aggregate Bond Index as their benchmark, and it requires two investment-grade ratings for a bond to be included in the index.

The upgrade is expected to spark positive ripple effects throughout the economy. It was immediately followed by another S&P ratings boost to investment-grade for nine Brazilian banks, which have benefited from a consumer spending boom that has produced a surge in housing construction and automobile sales. Even though 33% of Brazilians live in poverty, and the country's per capita GDP is just $5,600—compared with around $7,980 in Mexico and $8,870 in Chile—domestic spending has been robust thanks to a steady drop in inflation, which fell from the triple digits in the 1990s to just 4.5% in 2007.

Brazilians are spending not only on durable goods but also on wireless telephone service, airline travel, and education. "One of the positive things we've seen with the improvement in Brazil's economy is that people on the lower end of the income scale are doing a lot better," says Schineller of S&P. "Brazil still has a lot of poverty, but if that could be remedied, it would mean an even stronger consumer environment.