Is Brazil as risky as CDS prices suggest?


Jeremy Weltman
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Brazil is a riskier portfolio option than Mexico, according to live data from Euromoney’s Country Risk Survey, but the data suggest the risk differential is smaller than is currently priced into the credit default swap market.

Brazil’s risks may not be as striking as its credit default swap spreads suggest, according to Euromoney Country Risk (ECR) Survey Data.

On an ECR score of 59.4 out of a possible 100, Brazil currently ranks 39th out of 186 countries on Euromoney’s global scoreboard, three places below Mexico but still toward the top of the third of five tiered categories normally associated with triple-B or A- rated sovereigns.

Brazil’s ECR score had been on a negative trend in the 12 months to December, falling 1.2 points over the period, with economic indicators showing distinct signs of weakness amid a currency sell-off.

But the country’s score levelled out in the fourth quarter of 2013, suggesting that experts saw little additional risk in the economic and political environment during the period.

Brazil’s ECR score has softened slightly in the fourth quarter to date, with Mexico’s score marginally improving, so that the two Latin American countries are now 2.1 points apart (see table), and distinguished accordingly, it might seem, by the main credit ratings agencies, given the lower ratings attached to Brazil.

In contrast, data supplied by Markit show a substantialt gap has opened up in the cost of five-year CDS for the two sovereigns (see chart), averaging some 100 basis points in December to date. The two had been hitherto tracking quite closely through to July this year when ECR trends were developing (Brazil’s score falling; Mexico’s rising).

The gap was half the current figure back in October and virtually non-existent before July 2012. The CDS market seems to have reacted with a lag, but has then exaggerated the risks.

CDS spreads for both China and Malaysia, which are similarly ranked sovereigns on ECR’s scoreboard, have broadly tracked Mexico’s, displaying a quite distinct pattern from Brazil in recent months.

Comparing risks

The two sovereigns crossed paths in risk terms around the mid-point of this year, with Brazil’s score edging downwards and Mexico’s rising on diverging trends.

Economic growth returned to Mexico during the third quarter in response to improving manufacturing production, highlighting its better export prospects with the US revival cranking up the maquila sector. Its economy should receive further support next year from recent interest rate cuts and planned fiscal stimulus measures.

In contrast, Brazil’s economy contracted in the third quarter and the onset of elections next year is creating some political uncertainty, but in year-on-year terms GDP increased by 2.2%, beating Mexico’s 1.3%. Moreover, government stability would appear to be more of a risk for Mexico than Brazil, Euromoney’s survey suggests, in spite of the election calendar.

Drilling down into the various contributory factors reveals that the risk indicator scores for each sovereign are surprisingly similar. Each country wins out on five factors each when the economics and politics are compared. Brazil is a touch behind Mexico on its structural problems, too, but there is no discernible difference in bank stability, one of the five economic indicators, where the two are matched on a fairly reasonable score of 6.5 out of 10.

Brazil is trailing Mexico on its economic outlook, its currency stability, government finances, regulatory and policy environment and transfer risks, the experts’ scores indicate. However, Brazil beats Mexico on employment, corruption, transparency, institutional risk and government stability.

Statistics included in Brazil’s latest article IV country report from the IMF show a relatively low level of net debt, at just 35% of GDP, whereas Mexico’s is higher. Brazil can also count on some $380 billion-worth of foreign-currency reserves, sufficient to cover 13 months of imports. Real GDP growth is forecast to accelerate above 3% next year and there is ample scope for a fiscal adjustment to assuage market concerns.

It is true that Brazil’s risks have increased, but it remains one of ECR’s high-flying tier 3 sovereigns. On this basis, the market pricing appears to resemble an over-reaction.

Brazil is experiencing a structural slowdown in its rates of growth, it has a larger current account deficit, a less benign structural deficit and gross government debt, and inflation expectations are starting to look worrisome.

Moreover, Mexico’s investment is dependent on national saving, but Brazil’s is co-funded by external funding. ECR expert Constantin Gurdgiev, adjunct professor at Trinity College Dublin, states: “This implies that Brazil’s economy is vulnerable to investment stops and credit shocks from abroad. The Mexican economy is relatively less risky from this perspective”.