Many Brazilian state operating margins will erode over the near term, Fitch Ratings says. States spent in excess of their budgets in 2014 due to the general elections held last October. We believe spending cuts will be politically challenging, tax increases are reaching their limits, and using pension systems' assets to cover current expenditures is adding to the risk.

The states' expenses are showing significant rigidity and the measures proposed to streamline some state overheads are facing enormous opposition. Protests have forced the legislative chambers to defer any decision on these measures. Steps they can take, including closing down departments and reducing temporary employees, are not sufficient to curb expenditures. We expect payments to state contractors to be delayed and their agreements to be reviewed more often. We also believe the obligations linked to public private partnerships, signed in previous years, may be delayed.

Revenues are also facing pressures. Brazil's economic slowdown is worse than many expected and has heightened many private investors' risk aversion to the region. The continued drought is likely to force water rationing, particularly in Sao Paulo (BBB/AA+(bra)/Stable). Oil royalties have declined. The state of Rio de Janeiro (BBB-/AA-(bra)/Stable) is the most exposed to those declines.

In our view, state tax increases may be risky. Fuel tax increases will go into effect in April. However, the size and availability of the grey market makes tax collection on other parts of the economy difficult. Some sources estimate the informal economy is as high as 30% of total output.

We expect a few states to consider using pension reserves to satisfy current expenditures. Minas Gerais did so during financial turbulence in the mid-2000s. Parana (BBB-/AA+(bra)/Stable) has announced plans to do so. The state's pension system, ParanaPrevidencia, reported some BRL8 billion (USD2.8 billion) of liquid assets in 2014. As the state is responsible for pension payment, it argued that it could use those assets to partially cover for the financial obligations.

Additional information is available on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

Applicable Criteria and Related Research:

Sao Paulo, State of

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749662

Rio de Janeiro, State of

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=785068

Parana, State of

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=731478

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Fitch RatingsPaulo FugulinDirectorInternational Public Finance+55 11 4504-2206Alameda Santos, n 700Sao Paulo, BrazilorCarlos Vicente RamirezSenior DirectorInternational Public Finance+57 1 347 4573Calle 69 ABogota, ColombiaorRob RowanSenior DirectorFitch Wire+1 212 908-915933 Whitehall StreetNew York, NYorMedia Relations:Elizabeth Fogerty, New York, +1 212-908-0526Email: elizabeth.fogerty@fitchratings.com