Moody's Investors Service on Tuesday warned it may cut Brazil's credit rating in the next couple of years as the country's economy slows, piling pressure on the winner of October's presidential elections to change course on economic policy.
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Ahead of the Oct. 5 vote, debate about whether to tighten fiscal policy is a hot campaign topic. President Dilma Rousseff, who has indicated she won't radically alter policies if re-elected, faces a strong challenge from environmentalist Marina Silva, who is keen to cut government spending.
Rousseff did not directly respond to Moody's, but the Finance Ministry said the ratings agency based its decision on temporary factors that hurt growth in the first half of the year without taking into account a possible recovery in the next few months.
Aecio Neves, the market favorite for the elections and who stands third in opinion polls, said Moody's decision is a reminder that Brazil's social and economic progress is "at risk" due to fiscal indiscipline.
Under Rousseff, growth has slowed to an average of less than 2 percent a year. The economy fell into recession in the first half of 2014, while heightened government spending has led to an increase in Brazil's debt burden.
Moody's revised its outlook on Brazil's Baa2 rating to negative from stable, saying the rating could be downgraded if it sees indications the next government will not tighten fiscal policy and if growth remains at a low 1 to 2 percent.
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"Should the deterioration in the country's key credit metrics ... remain unchecked during the first two years of the incoming administration, this can significantly undermine Brazil's sovereign creditworthiness," Moody's said in a statement.
The firm expects Brazil's gross domestic product to expand by less than 1 percent in 2014 and less than 2 percent in 2015.
A "marked deterioration" in investor sentiment caused by "widespread market perception about the interventionist approach of the current administration" contributed to the decision, Moody's said.
Some investors criticized the timing of the announcement, coming less than five weeks before the elections. But Moody's analyst Mauro Leos said that earlier this year he had not been able to anticipate that Brazil's economic and fiscal performance would be as bad as it has turned out.
"We did not contemplate that there would be a recession this year," he said.
Brazilian markets slipped further after the warning, with many analysts considering a downgrade almost inevitable. Both the real and the Bovespa stock index closed with losses of nearly 1 percent, also hurt by an opinion poll that showed Rousseff narrowing Silva's lead in a likely runoff in late October.
A downgrade could add to Brazil's problems as it could increase government borrowing costs.
"The downgrade will come in the beginning of next year," said Marcos Casarin, an economist with Oxford Economics in London.
Standard & Poor's cut Brazil's credit rating to the near junk status of BBB-minus in March. Fitch Ratings is the only one of the big three ratings agencies to keep a stable outlook on Brazil with a BBB rating, equivalent to Moody's Baa2.
(By Walter Brandimarte; Additional reporting by Silvio Cascione, Alonso Soto and Jeferson Ribeiro in Brasilia; Editing by W Simon, Cynthia Osterman, James Dalgleish and Leslie Adler)