OREANDA-NEWS. As Brazil's government-sponsored Banco Nacional de Desenvolvimento Economico e Social (BNDES) likely scales back its role in infrastructure financing, the federal government expects more active participation of private lenders in addressing the infrastructure financing needs of the country, a goal that Fitch Ratings says will not be easy to achieve. Key to Brazilian banks' participation will be obtaining adequate long-dated funding that matches the long tenors of infrastructure loans.

Another necessary outcome of BNDES's diminished role will be the development of capital market instruments linked to project infrastructure that are attractive to local investors looking for steady returns and low risk. This will be one of the key items on the government's agenda in an effort to ensure a smooth transition. If successful, this could provide an important boost to Brazilian banks' capital markets fee income.

Announcements by both the Brazilian government and BNDES's president point toward a desired reduction in the development bank's role as the main source of financing for investments and infrastructure projects in the country, opening opportunities for private sector lenders, in our view.

The driver of BNDES's reduced role in infrastructure lending will be declining government subsidies that make part of Brazil's fiscal tightening agenda. Brazil's Treasury's loans to BNDES at below-market rates have been partially responsible for the increase in general government debt over recent years. The government's tightening measures include the reduction of transfers to BNDES and increasing the interest rates on these loans, which are indexed to TJLP (taxa de juros de longo prazo, a rate set by the National Monetary Council). The bulk of BNDES's loans are also linked to TJLP.

The government has stated that the Treasury will not provide additional loans to BNDES in 2015. Fitch believes that BNDES's disbursements and loan growth will fall in tandem with the decline in funding from the Treasury, which made up 61% of its total funding at the end of 2014. In 2014, the bank received BRL60 billion of funding from the Treasury compared to BRL41 billion in 2013. Its loans grew 15% in both 2014 and 2013, while its loan disbursements remained roughly unchanged at BRL188 billion in 2014.

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The large differential between market rates and TJLP has resulted in favorable borrowing conditions for infrastructure borrowers, but has also created a high subsidy burden for the government. TJLP was recently increased to 6%, from 5.5% in first-quarter 2015 and 5% in 2014, but remains well below Brazil's Selic, the benchmark interest rate, which was raised to 12.75% in March 2015. Further increases in TJLP are possible. However, any potential increase is likely to be limited since debt service is added on to the principal for any rate above 6.0%, which could lead borrowers to face difficulties in debt servicing. An alternative for BNDES would be to reduce the share of its TJLP linked loans.

BNDES held an approximately 22% market share of total sector loans in 2014. However, its share in total project finance loans is estimated to be much higher. As private lenders participate more actively in addressing Brazil's long-term financing needs, infrastructure borrowing costs would be expected to increase over the short term. As such, operational cash flow generation for the project would need to be higher (i.e. higher tariffs) to maintain the same ability to pay debt service. This effectively transfers the project's cost to those who directly benefit from the infrastructure rather than through the general tax base.

BNDES's financial profile and asset quality remained broadly stable in 2014. However, Fitch expects an increase in impaired loans and credit costs in 2015. These will stem from the bank's exposure to the oil and gas and construction sectors, which are currently undergoing duress as a result of the fallout from the investigations surrounding Petrobras.

The main alternative being developed by Brazil's government to compensate the government funding cut is developing fixed-income instruments that will wean large companies off state-subsidized loans. Such instruments can provide incentives for the borrowers to sell bonds in the local capital markets. Also, alternatives are being studied to create fixed income instruments that are both attractive to foreign investors and linked to infrastructure projects. Fitch remains skeptical of further foreign fixed income investor interest for longer-tenor projects in the local currency given high hedging costs, but expects that private sector banks would likely play some role in the development of these alternatives.