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How a Brazilian Downgrade Hurts Itau Unibanco, Banco Bradesco, and Banco Santander

Bad news is coming from the emerging markets again. On Monday, Standard & Poor's decided to cut Brazil's credit rating, arguing that the sluggish economic growth and its expansionary fiscal policy are increasing the country's debt levels. This could have an effect on Brazilian bank ADRs, including Itau Unibanco Holding (NYSE: ITUB  ) , Banco Bradesco (NYSE: BBD  ) , and Banco Santander Brasil (NYSE: BSBR  )

The country's one-level downgrade from BBB to BBB- puts Brazil in line with countries like Spain and the Philippines, but one notch below Russia and two below Mexico.

What's going on in Brazil?
A couple of things are going on. To start with, there is increasing concern over the fiscal situation in the country. Last year, Brazil missed its fiscal target and generated a budget gap of $64.9 billion. This year, with the FIFA World Cup and the presidential elections in October, higher spending is very likely to continue.

There's also inflation, which although remains within manageable levels, reached 6.21% for 2013. Brazil's expansionary fiscal policy unfortunately makes it harder for the country to stop runaway inflation, but for now targets are being met.

What's the outlook for Brazilian banks?
Itau Unibanco Holding (NYSE: ITUB  ) , Banco Bradesco, and Banco Santander Brasil are being affected by a few things happening in the country.

First, these banks hold large positions in the country's $2.15 billion of bonds due 2023, which now hold higher risk. In fact, according to data compiled by Bloomberg, yields climbed to 4.26% in the past year. This means two things: a drop in bond prices, and an increase in interest rates.

Second, the upcoming elections have made the government maintain its massive subsidized loan policy. This has directly affected these banks' loan pricing and net interest margins. In fact, for Itau Unibanco, net interest margin went from 11.4% in the first quarter 2012 to 9.1% in the fourth quarter 2013, and similarly, for Bradesco the average interest margin went from 7.6% to 7.1% in the same period. It is important to note that three of the five largest Brazilian banks are government controlled, and they have been increasing their lending. This is making it tougher for the mentioned banks to get a higher share of the same market.

Third, the context of higher interest rates and lower GDP growth is affecting expectations and the activity levels. This is very likely to slow down the overall banking business. S&P expects Brazil's to grow 1.8% this year, much less than 2013's GDP growth of 2.3%. In fact, Brazil has dealt with moderate growth in its economy for the last three consecutive years: 2.7% in 2011 and 1% in 2012. Hence, the scenario is not the best.

Final foolish thoughts
This downgrade doesn't bode well, as it ends a decade-long stretch of upgrades for the country. It also puts Brazil in a riskier situation, since BBB- is the lowest investment-grade rating.

The conjunction of fiscal slippage with subdued growth in the coming years will make it more difficult to raise taxes and bring down the deficit. In addition, the chances of fiscal policy adjustments before the end of the FIFA world cup and the October presidential elections are remote.

Nonetheless, the outlook for Latin America's biggest economy is stable. We won't see further downgrades any time soon, unless severe unexpected issues come up.

Regarding Brazilian banks, the best advice is to stay alert since financial institutions are usually the first ones to make corrections when economies show weaknesses. If the country were to lose its investment-grade status, it would be catastrophic for the banks and the overall economy. For now, though, this scenario remains very unlikely.

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Louie Grint

I am a curious economist who likes to investigate what is behind asset price movements across the globe. My articles range from industry analysis of various sectors to understanding global macro events that could trigger volatility in the markets.

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