In June 2011, Moody's Investors Services reviewed the credit ratings of two regional players in the Latin American and Caribbean sphere, the Federative Republic of Brazil and Barbados. Moody's upgraded the government bond rating of the South American powerhouse, Brazil, to Baa2 from Baa3, and the foreign currency rating to Baa1 from Baa2. According to Moody's, this upgrade was justified by a strengthening economy and recent policy adjustments which would result in sustainable growth of the Brazilian economy. In contrast to Brazil, Barbados' local currency rating was downgraded to Baa3 from Baa2, while its Baa3 foreign currency rating was affirmed. The outlook on both of Barbados' currency ratings was revised to negative, reflecting the agency's concerns about the country's high debt levels and the expected increase of the already large current account deficit. In this piece, we will delve deeper into the events surrounding these ratings actions and the implications on these countries' fixed income securities.
Brazil
Brazil, one of the key emerging nations, has been reaping the benefits of steady economic expansion owing to a highly diversified economy, high levels of foreign currency reserves (the seventh largest in the world) and low levels of foreign currency denominated government debt. The country also enjoys relatively low levels of political and economic risk due to the political stability of the nation. As such, it is hardly surprising that Brazil's government bond credit rating was upgraded to Baa2 and the foreign currency rating to Baa1 to reflect the resilience of the economy.
The Brazilian economy has been growing rapidly, fuelled by elevated commodity prices, strong domestic demand and high levels of capital inflows. While encouraging economic expansion, these factors have also led to fears of overheating, which are rooted in the country's inflation woes (the May inflation rate was 6.55 per cent) and inflated asset and credit prices, signalling a possible credit bubble. Apart from inflated asset prices, evidence of a possible credit bubble is seen in the increase in the bank loans to gross domestic product (GDP) ratio. This ratio rose to nearly 50 per cent in 2011 from 24 per cent in 2003.
While this significant increase may be a cause for concern, it should be noted the credit to GDP ratio of Brazil is lower than the ratios of other emerging nations (Figure 1). Additionally, Moody's indicated the relatively high capital ratios of Brazilian banks reduce the likelihood of a banking crisis in the country.
The Brazilian economy seems to be on the path to sustained development as the government's monetary and fiscal policies attempts to moderate growth efforts. Moody's stated one of the country's major strengths was the government's commitment to implementing measures aimed at slowing growth to a more sustainable pace. The adoption of conservative fiscal and monetary policies is expected to result in declining debt ratios and an improvement in the government's fiscal standing.
Barbados
In Moody's first credit rating review of Barbados in 18 months, the agency lowered the country's domestic currency rating to Baa3 from Baa2, while affirming the Baa3 foreign currency ratings. Moody's indicated the downgrade reflected the increase in Barbados' current account deficits and high debt levels. However, this downgrade by Moody's is comparable to the BBB- credit rating S&P assigned to Barbados in November 2010, owing to the expected rise in government debt levels and the country's slower than expected recovery efforts. Barbados' economy is primarily driven by the tourism sector (which accounted for 14.7 per cent of GDP in 1Q 2011), resulting in the country's fortune being linked to the economic performance of the advanced economies such as the United Kingdom, United States and Canada.
As such, the open nature and relatively low levels of diversification within Barbados' economy magnified the effects of the global economic crisis.
The decline in the tourism industry, the country's main foreign exchange earner, resulted in a contraction of Barbados' growth in 2009. Increased government expenditures aimed at spurring economic activity, coupled with declining revenues from the tourism sector led to increased government borrowing on the domestic market and higher debt to GDP ratios, as illustrated by Figure 2. Moody's noted the downgrade of Barbados' domestic currency came in the wake of expected increases in the country's debt levels within the next 12-18 months. The ratings agency also indicated the capital controls previously used by Barbados' government to regulate capital inflows into the country historically resulted in increased demand for local government debt. However, Moody's expressed concerns about the local market's ability to absorb the elevated level of government debt since this demand was now eroded.
Notwithstanding the downgrade in the domestic currency credit rating, Barbados remains within the investment grade range. Barbados' government is now faced with the daunting task of ensuring sustained fiscal consolidation to facilitate economic stability within the country. Recent increases in taxes and restraint in government expenditure seems to be a step in the right direction, as the government attempts to improve the island's fiscal position.
Fixed income considerations
As previously mentioned, Brazil's asset prices have appreciated substantially. Global liquidity and general risk taking have led investors to high-yielding assets in emerging markets, such as Brazil's sovereign and corporate bonds. As such, many existing Brazilian bond issues showed little reaction to the upgrade. However, investors interested in Brazil's bonds can consider newly issued corporate bonds in the country's strong financial sector. Additionally, Brazil's thriving energy sector provides ample opportunity for investors seeking some level of safety and decent returns.
Investors are cautioned to extend their investment horizons within five to seven years. Limiting duration in this way allows the investor to minimise interest rate risk in a rising interest rate environment. Additionally, while the local currency rating of Barbados was downgraded, both the domestic and foreign currency ratings remain of investment grade with a Baa3 rating. Moody's action brings the rating in line with S&P's BBB- rating for both the local and foreign long term ratings. Hence, there was little price movement on the US$ denominated debt. As such, investors may consider Barbados US$ denominated sovereign debt and local companies, such as Sagicor's 2016 bond issue, which can generate relatively good returns.
Conclusion
Following the effects of the global economic crisis on the Latin American and Caribbean region, some Latin American countries recovered swiftly while others, such as the tourism based Caribbean economies' growth efforts remains stunted. Brazil's economy has been performing strongly, benefiting from abundant natural resources and a diversified economy enabling an improvement in its credit standing. However, Barbados' tourism-based economy faces a challenge in maintaining government debt at sustainable levels in order to prevent a further downgrade of the country's credit ratings. It should be noted that these economies are both still attractive as investments and may be considered by investors who wish to invest within the region. As always, investors are recommended to seek consultation from a qualified investment advisor before undertaking any investment ventures.
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