Rating agency Standard & Poor’s downgrade last week of Brazil’s sovereign rating to the non-investment or “junk” category is a wake-up call for the country to correct its finances and build the political consensus to achieve that. Brazil is facing a severe recession, and its economy is expected to shrink by 3% this year and again in 2016, before returning to modest growth by 2017, according to S&P.

It does not help that an economic slowdown is also underway in China, Brazil’s main trading partner, hurting the latter’s exports to that country. Meanwhile, Brazil is wracked by corruption scandals involving senior politicians that threaten the stability of the government of President Dilma Rousseff, who is now in her second term. Despite those headwinds, experts feel Brazil still has time to correct its course, restore confidence among investors and lenders and avert another, potentially devastating downgrade.

“The junk rating is a big warning … [and] a big red flag,” said L. Felipe Monteiro, professor of strategy at INSEAD in France and a senior fellow at Wharton’s Mack Institute for Innovation Management. Monteiro is an expert on Brazil, having taught there and advised foreign companies investing in that country. “The likelihood of another downgrade depends on what Brazil does now to address the issues that have been raised.”

Monteiro discussed the implications of the downgrade for Brazil on the Knowledge at Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

Formidable Challenges

In its rating action last week, S&P cited mounting political challenges Brazil faces, “a lack of cohesion” in Rousseff’s cabinet and the possibility of “greater economic turmoil” than the rating agency currently expects. In particular, it noted repeated revisions to Brazil’s fiscal targets in a short period. Brazil’s government on August 31 proposed a budget with a primary deficit of 0.3% of its gross domestic product (GDP), instead of a 0.7% surplus it targeted in July, which also was a revision from earlier estimates. “This change reflects internal disagreement about the composition and magnitude of measures needed to redress the slippage in public finances,” S&P said in its research update last week.

Monteiro used the analogy of exercise and good health to explain Brazil’s downgrade. “Everybody knows we need to exercise and eat healthy, and when you have a heart attack,” he said. “I see the current downgrade as a heart attack. Brazil now needs to eat healthy and exercise.” If the country “continues to be in denial, the consequences would be much stronger than just a heart attack” and may risk the life of the patient, he added.

Already, Brazilian companies that took on $270 billion in international debt during the boom years are seeing their funding costs rise after the downgrade, according to a Bloomberg report. However, the downgrade has not yet caused widespread panic among global investors because the two other big rating agencies, Moody’s and Fitch Ratings, maintain an investment-grade rating for the country, said Monteiro. “If more than one rating agency were to downgrade the country, it could lead to a flight of capital from the country,” he said. Alongside, if the U.S. Federal Reserve were to signal higher interest rates, that would make it more expensive for Brazilian companies to raise money, he added.

“The junk rating is a big warning … [and] a big red flag.”

While Moody’s did not follow suit after S&P’s downgrade, it had a month earlier downgraded Brazil sovereign debt to Baa3, which is just below junk level. It also issued a “stable” outlook for the country at that time. Fitch Ratings has a credit rating of BBB for Brazil, which is two levels above junk level. However, a Fitch analyst told Reuters after the S&P action that there still are “elements supporting Brazil’s investment grade.” He added that the possibility of a Fitch downgrade is greater than 50%.

Monteiro said ongoing investigations into Brazil’s corruption scandals have “aggravated the political situation.” Over the years, hundreds of millions of dollars allegedly went into kickbacks to politicians, including those from Rousseff’s Workers’ Party, from contracts awarded by Brazil’s state oil company Petrobras. Investigations cover 20 companies for allegedly forming a cartel to inflate contract values, as Knowledge at Wharton reported in April.

“Rousseff faces a perfect storm insofar as her political stability is concerned,” said Monteiro. “She faced the corruption storm and the economic situation has made things worse for her.”

Responding to the Downgrade

Even as she may be politically constrained, Rousseff must take immediate steps to propose a new budget that addresses the major concerns about fiscal stability, said Monteiro. “There has been talk of raising new taxes and creating a temporary financial tax. But before that, they have to come up with credible measures to cut expenses,” he said. “The government should respond in a timely, professional, transparent and credible way.” He noted that the Rousseff government must also reassess social programs it (and its predecessor government) have committed to, and consider the feasibility of cuts.

“We don’t have time for political battles any more. The consequences of not doing something could be too high.”

Monteiro identified three “wrong reactions” to the downgrade. “One has been denial,” he said. He explained that it doesn’t help to question the credibility of the rating agency, as some politicians have. The second type of reaction has been to go overly pessimistic, he said. “This is not the end, and Brazil will get out of this or has all the conditions [necessary] to get out of this.” The third type he criticized was “an amateurish reaction” that expressed shock or surprise. “The downgrade was not an accident,” he explained, adding that it was widely expected, if not its precise timing.

The impact on Brazil of China’s slowdown would be limited, Monteiro said. He acknowledged that China is a big importer of commodities from Brazil and that falling prices have hurt the latter. “However, Brazil is not an export-oriented economy, and its strength lies in its domestic markets,” he said. “Part of the solutions should come from Brazil’s ability to get the economy back on track and make the internal market work well again.”

Another big concern is that Brazil has shed about 900,000 jobs so far this year, Monteiro noted. Here, again, he saw the domestic economy as providing the requisite job growth opportunities. Brazil’s foreign trade accounts for only 12% of its GDP ($2.35 trillion in 2014), “which means much of the recovery has to come from within,” he explained. Brazil’s unemployment rate touched a five-year high of 7.5% in July 2015.

In achieving an economic rebound, Brazil must also create a more friendly business environment, said Monteiro. “Doing business in Brazil is very difficult with the bureaucracy, red tape and labor laws,” he said. The World Bank this year ranked Brazil 120th for 2015 out of 189 countries in terms of ease of doing business. The Bank also said last year that Brazilian courts in 2013 had to deal with 3.8 million labor lawsuits, and that companies had to spend too much time on resolving tax issues.

Even in these rough times, “the positives are that [Brazil’s] institutions … and its democratic processes … are working very well,” said Monteiro. “The judiciary has been free to pursue its mandates, and the press has been free to show what is going on.” Brazil’s citizens could also influence course corrections in the economy, and people have of late taken to the streets every few months, he noted. “Depending on the government’s reactions, we may see huge demonstrations again. They are on standby.”

Above all, Monteiro called for “a credible and professional reaction” from the government. “Many investors have lost patience with Brazil when they see promises that are not credible,” he said. “We don’t have time for political battles any more. The consequences of not doing something could be too high.”