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By Guillermo Parra-Bernal and Marcela Ayres
SAO PAULO/BRASILIA, April 7 (Reuters) - Banks in Brazil will step up corporate loan refinancing deals this year, the central bank said on Thursday, suggesting the impact of the harshest recession in over a century and escalating political turmoil are hurting the ability of factories, shops and farmers to honor their debt.
According to the central bank's semi-annual financial stability report, banks are having a harder time predicting default trends amid an uncertain economic outlook for Latin America's largest economy. A benchmark indicator for defaults hit a five-year high in February and is poised to climb further.
Brazil's longest and most intense recession since 1901, coupled with rising credit costs, kept straining the capacity of consumer and corporate borrowers to stay current on their debts, the report showed. Policymakers at the central bank expect banks to pare back disbursements further this year - lending is currently expanding at the slowest pace in at least 16 years.
Nevertheless, the country's banking system remains highly resilient to adverse events, even under extreme conditions, the report said. In a series of simulation exercises, policymakers found that banks have an adequate cushion to absorb default-related losses, although at the cost of declining profitability.
"Defaults will keep rising, but not in a explosive manner," said Anthero Meirelles, a central bank director in charge of oversight.
The financial stability report provides a thorough glimpse into loan-book quality and banking profitability as the nation's biggest lenders prepare to report first-quarter results this month. An index comprised of Brazil's financial shares added 1 percent on Thursday, extending year-to-date gains to 20 percent.
To weather the impact of the recession, an increasing number of debt-laden companies are selling assets or, in the worst case, seeking bankruptcy protection, which could make banks even more cautious in the future, said Marcelo Carvalho, chief Latin American economist for BNP Paribas SA. That could develop into a "vicious cycle" that could put the brakes on a recovery.
"Observers are missing one key factor in Brazil's near-term growth dynamics: corporate defaults," Carvalho wrote in a Thursday client note, referring to market participants' excessive attention to political bickering that could end on President Dilma Rousseff's impeachment.
Policymakers will continue to monitor the impact of a sweeping corruption scandal on bank balance sheets, the report said. The banking system is also prepared to withstand additional shocks such as sudden swings in currency and interest rates, or a pronounced decline in creditworthiness, the report noted.
Lenders in Brazil are mitigating the risk of growing interdependence between engineering firms, suppliers and services companies involved in the so-called "Operation Car Wash" scandal by lending more prudently and increasing requirements that additional guarantees be placed, the report added.
The latest central bank's monthly report on lending showed that provisions as a share of capital hit their highest level in almost four years for private-sector banks. (Additional reporting by Alonso Soto in Brasilia; Editing by Alistair Bell and Chris Reese)