Moody’s Investor Service downgraded its credit rating for Brazil to a single notch above junk status in early-September in the latest sign that economic growth is slowing and government policies aren’t working to stem the rapid decline. With slowing economic growth driven by lower commodity prices, a lack of political consensus on fiscal reforms, and deteriorating debt affordability, the credit rating agency believes the country could face some trouble ahead.

Slowing Economic Growth

Brazil’s gross domestic product is expected to contract by 2.3% in 2015, as lower commodity prices and a reliance on China take a toll on its export-driven economy. As a result of the slowing growth and the government’s failure to take monetary policy action, the Brazilian real has lost more than a quarter of its value during the first half of 2015. The lower valuation could make exports more competitive, but makes dollar-denominated debt more expensive to repay.

Compounding these problems, rising unemployment, falling wages, and weak consumption have reduced tax revenue and led to a budget deficit that could reach 8% to 9% of GDP. The country has historically focused on maintaining a budget surplus, while a fiscal responsibility law passed in 2000 could even make it illegal to have spending that outstrips receipts, which have both caused concerns for international investors.

Rising Debt Expenses

The slowing growth and budget deficit mean that Brazil will be forced to borrow money to cover its interest payments for the first time since its hyper-inflation era.

While that’s not a problem for developed countries running budget deficits, such as the United States, Brazil has the highest real interest rates of any middle-income emerging market economy at 14.25%, as of September 2015, although the rate was unchanged after seven consecutive hikes.

President Dilma Rousseff and her economic team demonstrated the extent of the economy’s financial and political turmoil when they submitted their 2016 budget proposal to Congress that did nothing to pay down the country’s soaring national debt. With record low approval ratings, President Rousseff has a weak political standing, while corruption charges against Lava Jato have contribution to tensions between Congress and the Executive Branch.

It’s Not All Bad News

The good news is that Brazil has ample international reserve buffers to withstand external financial shocks, a government balance sheet with limited exposure to foreign currency debt, and a large and somewhat-diversified economy. While these dynamics are certain a positive in the near-term, they could change over time due to a number of factors. The country could decide, for example, to defend its currency in the foreign exchange market.

In terms of its debt, Brazil’s debt-to-GDP ratio is likely to approach 70% by 2018, when President Rousseff leaves office, but economists believe that it should stabilize at those levels and the economy could rebound from lows that it reaches in 2015 and 2016. A correction in the global economy – and particularly China – could be resolved that time and set the stage for an increase in commodity prices from their currently-low levels.

Take Takeaway Points

• Moody’s Investor Service downgraded Brazil’s debt to a single notch above junk status in September 2015, in a sign that the economy has been weakening.
• There are a number of factors that play into the economic weakness that international investors should consider and keep an eye on over the coming years.
• Many economists believe that the country could recover from its problems if it reaches a political consensus by 2018 when President Rousseff leaves office.