Lula’s spending plans turn heat on Brazilian markets

Brazil’s financial markets have sold off sharply this year as investors grow increasingly anxious about the spending plans of leftwing President Luiz Inácio Lula da Silva’s government.

The Brazilian real is the third-worst performing emerging market currency against the US dollar so far this year, its near-10 per cent decline ranking behind only the Turkish lira and the peso of perennially troubled neighbour Argentina. Meanwhile, the local Bovespa equity index has dropped 8.6 per cent over the same period. 

While emerging markets in general have been hit as investors dramatically scale back their expectations for US interest rate cuts this year, money managers and economists also cite growing concerns over the viability of Brasília’s plan to balance the public finances through extra tax collection, while also increasing spending. 

“Today, fiscal risk is what weighs most on the Brazilian economy and the markets,” said Ricardo Lacerda, chief executive of local investment bank BR Partners and former head of Goldman Sachs in Brazil. “We are not yet in an out-of-control zone. But the government has bet on an unsustainable model of fiscal adjustment without cost-cutting.” 

Lula returned to power last year on pledges to boost welfare spending and expand the state, hoping to emulate the political success of his previous spell in government between 2003 and 2011. His administration sought to reassure investors by promising to eliminate the so-called primary budget deficit, which does not include debt interest payments.

But it has already watered down its own targets for achieving a surplus from next year onwards, and has committed to increasing expenditure in real terms annually. Some investors and analysts fear it will fail to eliminate the deficit this year as planned.

Public debt levels — already relatively high for an emerging market at 76 per cent of gross domestic product — are now not forecast to fall until 2028, according to official estimates. 

Market volatility has intensified after the government earlier this month failed to win parliamentary backing for its proposal to curtail corporate tax credits following an outcry from business, piling pressure on finance minister Fernando Haddad, whom Lula was later forced to defend.

“This showed that we’re hitting the limit of the model of fiscal adjustment proposed by Haddad,” said Helder Soares, chief investment officer at asset manager Principal Claritas in São Paulo. “The structural fiscal position is not hopeless, but it is delicate.” 

Brazil has a history of running budget deficits, often with negative knock-on effects for inflation, interest rates and economic activity. 

Critics argue the loose fiscal stance limits the ability of the central bank to lower its base rate, which at 10.5 per cent has been attacked by Lula as harmful to growth.

Economists predict GDP growth will come down to 2 per cent this year from 2.9 per cent last year. While consumer price rises have slowed, forecasts for full-year inflation have crept up to 4 per cent, above the official target of 3 per cent. 

“The primary deficit is unlikely to be zeroed in 2024 and could be even greater in 2025,” said Rafaela Vitoria, chief economist at Banco Inter, who said fiscal policy was starting to feed through to inflation.

She calculates that public spending has grown by about 6 per cent above inflation per year since Lula took office at the start of 2023, and added: “There are no containment mechanisms for 2025.”

Analysts and market participants say concerns about the budget deficit and fears of political interference in central bank decisions have led investors to demand higher yields for holding the country’s debt, pushing up its borrowing costs.

In defiance of Lula, the bank on Wednesday paused its easing cycle. The monetary policy committee’s unanimous decision helped soothe a potential credibility crisis for the institution, after members appointed by the leftwinger pushed for a bigger rate cut in May. 

Despite the Bovespa edging up slightly the following day, the real touched R$5.46 to the dollar — its weakest level since Lula’s inauguration. The currency pared some of its losses to close at R$5.39 on Monday.

“Any bounce in asset prices will be shortlived unless the government finds a more sustainable solution to address the imbalances in the budget,” said John Stavliotis, portfolio manager at Antipodes Partners.

Bulls argue that Brazilian stocks — trading at seven times forward earnings — are historically cheap. This year to the end of May, the FTSE Brazil All Cap index is ranked 49th out of 50 country indices tracked by the data provider. 

In the wake of investor disquiet and the failure to gain backing for the corporate tax credit plan, Haddad has raised the possibility of spending cuts in certain areas. However, he faces resistance from within his ruling Workers’ party, while Lula has said ministers must convince him of the necessity. 

Supporters of the government and some investors argue that Brazil’s primary deficit — forecast by the IMF to be 0.6 per cent of GDP this year — is relatively small compared with countries such as Mexico, where the budget shortfall is expected to reach nearly 6 per cent.

Even so, commentators see little appetite in government for significant cutbacks ahead of municipal elections in October. 

“[Lula] had a honeymoon in his first year and that’s coming to an end,” said Jean Van de Walle, chief investment officer at family office Sycamore Capital. “There will be a growing clash [between] monetary orthodoxy and the government’s ambitions.”

Additional reporting by Mary McDougall in London