Brazil downgraded to 'junk' rating by S&P, deepening woes

S&P cut Brazil's rating to BB-plus, the highest junk rating, from BBB-minus.

It warned less than two months ago that a downgrade was possible but the unusually fast move underscores how quickly Brazil's economy and public finances have deteriorated since then. The outlook on the new rating remains negative, which means additional downgrades are possible in the near term.

The investment-grade rating was a key imprimatur that solidified Brazil's emergence as an economic power during a decade-long commodities boom that fizzled in recent years as the Chinese economy, Brazil's biggest export market and once ravenous for its raw materials, began slowing.

Further fallout from the downgrade will depend on how other major ratings agencies respond. While there will be some sharp falls in asset prices now, a flood of "forced selling" is not expected until a second agency also drops Brazil to junk status.

Forced selling occurs when passive investors, who do not actively manage their foreign assets, divest because the assets they hold are removed from investment-grade indices they track.

Fitch Ratings currently rates Brazil at BBB, two notches above investment grade, with a negative outlook. Moody's Investors Service downgraded Brazil less than a month ago to the brink of junk, but said its investment grade was safe for now.

S&P said on Wednesday its decision was based on the mounting political problems that have muddled economic policy.

These problems, S&P said, have been weighing on the government's "ability and willingness" to submit a 2016 budget consistent with the significant policy fixes Rousseff promised after she won re-election last year.

Finance Minister Joaquim Levy responded by saying the government would in the coming weeks send to Congress proposed savings measures to guarantee a primary budget surplus in 2016 - a reversal from late last month in which Rousseff proposed a budget that forecast a deficit.

Planning Minister Nelson Barbosa said the government would continue to honor its financial commitments.

Still, the downgrade caught Rousseff's economic team by surprise. One person at the finance ministry, who requested anonymity, said it was too early to determine how it will affect the government's austerity efforts.

'DISASTER WAITING TO HAPPEN'

Opposition leader Aecio Neves, a senator for the centrist PSDB party who narrowly lost to Rousseff in last year's election, called the downgrade "a disaster waiting to happen, the result of the government's incompetence and mistakes."

He said Rousseff lacked the support she needs to undertake the pending reforms.

Investors, meanwhile, speculated whether the move would serve as a wake-up call for the government and Congress to move faster, and in concert, or whether it would encourage Rousseff to change tack and boost spending once more to stimulate the economy.

"Now that the battle to preserve investment grade is lost ... there is some probability that the government could waver even further," Goldman Sachs senior economist Alberto Ramos said in a note to clients.

When Brazil first got the coveted investment-grade stamp from S&P, after decades of financial volatility, it was considered a star among developing nations.

Leveraging soaring export and tax revenues at the time, the ruling Workers' Party broadened generous social welfare programs and encouraged lending by public banks, fueling a prolonged consumer boom. Combined, the measures lifted 40 million people out of poverty.

Once Rousseff took office in 2011, however, the economy began to slow down sharply and last quarter it officially entered a recession.

The economy has also been weighed down by a massive corruption scandal at state-run oil firm Petroleo Brasileiro SA , freezing many infrastructure investments.

Brazil's currency, the real, has lost a third of its value this year and the inflation rate has jumped to almost 10 percent.

The economic crises and the corruption scandal have both battered Rousseff's approval ratings, which are now in single digits, fuelling opposition calls for her resignation or impeachment.

Following the downgrade, some traders late on Wednesday said the currency could plunge to a 13-year low of 3.9 per dollar on Thursday. Others reviewed circuit breaker rules that could be triggered to stem volatility when local markets open.